Chancery Considers Permissive v. Exclusive Forum Selection Clauses

The Delaware Court of Chancery found that a forum selection clause that was merely permissive rather than exclusive, did not justify enforcing one forum only. In the case styled In re Bay Hills Emerging Partners, I, L.P., C.A. No. 2018-0234- JRS (Del. Ch. July 2, 2018), the court was presented with a case challenging the removal of general partners of a Delaware limited partnership. Many prior decisions upholding (mostly) exclusive forum selection clauses have been highlighted on these pages over the last 13 years.

Brief Background Facts:

Shortly after the Delaware action was filed, the limited partner initiated litigation in the Commonwealth of Kentucky in which it sought judicial declarations that its removal of the general partners was proper, along with other legal and equitable relief.

The defendants in Delaware moved to dismiss the action primarily on the basis of the forum selection clause in the relevant agreements that required the plaintiff in the Delaware case to litigate the dispute in Kentucky. The court disagreed, primarily because the applicable forum selection clause was only permissive, and not a mandatory, exclusive forum selection clause. This is recurring issue in corporate and commercial litigation.

The applicable clause stated that Franklin County Circuit Court in Kentucky is “a proper venue” but it did not designate that court as the “exclusive” forum.

Procedural Posture:

Even though the Kentucky action was filed eight days after the Delaware action, and the claims were nearly identical, the court sua sponte decided to stay the Delaware action in favor of the Kentucky action.

The court reviewed the motion under Rule 12(b)(3), which does not limit the court to the complaint but allows the court to consider extrinsic evidence. In addition to the forum selection clause, the motion to dismiss the Delaware action was based on forum non conveniens as well as “the interests of comity” and the doctrine of sovereign immunity because the Commonwealth of Kentucky was one of the interested parties.

Analysis of the Court:

One of the more interesting aspects of this decision was the analysis of 6 Del. C. § 17-109(d) which prohibits limited partners from waiving the right to litigate matters relating to the internal affairs of the limited partnership in the courts of Delaware.

Forum Selection Clauses:

The court recognized the well-settled rule in Delaware that courts generally should give effect to the selection in a private agreement to resolve disputes in a particular forum.

The Delaware courts often grant motions to dismiss where the parties use express language clearly indicating that the forum selection clause excludes the court where a party improperly filed an action. See footnotes 33 and 34.

Choice of Law Clauses:

There was a choice of law provision in this agreement which provided that the laws of the Commonwealth of Kentucky apply regardless of choice of law principles.

Delaware courts generally honor contractually-designated choice of law provisions, as long as the jurisdiction bears some material relationship to the transaction. See footnote 36.  In this case there is little doubt about the material relationship to Kentucky because the limited partner in each of the limited partnerships involved was a statutorily created entity that manages the retirement systems for the Commonwealth of Kentucky.

Notably, the court referred to the cases where there is a “false conflict” meaning that there is no material difference between the laws of competing jurisdictions–in which case the “court should avoid the choice of law analysis all together.” See footnote 38.  The court applied that principle in this case to decline to undertake a choice of law analysis.

Key Takeaways:

The key rulings with the most widespread applicability that can be gleaned from this case are the following:

1)         Where two cases are filed within a short time of each other, the court will treat them as being filed contemporaneously, and a forum non conveniens analysis will apply.  In this case it applied to favor a stay of the Delaware case and an application of Kentucky law because there were no unique issues of Delaware law presented.

2)         The court recognized the general enforceability of forum selection clauses, as well as choice of law provisions.  Many forum selection clause cases have been highlighted on these pages.

3)         The court observed that both the Delaware LLC Act and the Delaware LP Act prevent non-managers of LLCs and non-general partners of LPs from waiving their right to litigate internal affairs issues in Delaware, but those provisions do not require them to litigate in Delaware; nor do those provisions require LLC managers or general partners of limited partnerships to litigate in Delaware.

Chancery Disregards Corporate Entity to Allow Debt Collection

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.

Chancery Addresses Indemnification Claim

The Delaware Court of Chancery in Daugherty v. Highland Capital Management, L.P., C.A. No. 2017-0488-SG (Del. Ch. June 29, 2018), primarily addressed the issue of laches and equitable tolling that constituted the majority of the 29-page decision, but the last two pages relating to indemnification are the most memorable aspects of the opinion.  The procedural history of the case is relatively lengthy and somewhat involved.

The most noteworthy aspect of this case is the indemnification claim. The parties in this case were involved in lengthy litigation in Texas after which the party seeking indemnification brought suit in Delaware.  One of the issues was whether it too long to proceed in Delaware.  The indemnification claim was not barred by laches based on an extensive analysis by the court of the facts of the case.

The most widely applicable bullet points from this case regarding indemnification are the following:

  • “A cause of action for indemnification accrues when the officer or director entitled to indemnification can be confident any claims against him have been resolved with certainty.” See footnote 120 (quotations omitted).
  • The court explained that the “certainty” required as a prerequisite for indemnification “requires the resolution of any appellate review.”
  • As a general matter, “adjudicating indemnification claims piecemeal is highly inefficient.” See footnote 122.
  • The court also rejected the defense that the indemnification claims related to personal contractual obligations as opposed to acts performed in the name of the entity against whom indemnification was sought, but the court found at the early pleading stage it was reasonably conceivable that the claimant was acting in his position as an employee of the entity with respect to at least some of the claims defended in the Texas litigation for which he is seeking indemnification.

Chancery Applies Entire Fairness Standard to Transaction with Controller

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.

Chancery Awards Interim Fees Based on Fee-Shifting Contract Provision

A recent letter ruling of the Delaware Court of Chancery awarded interim fees based on a fee-shifting contract provision, prior to the final conclusion of the case, based on pre-trial rulings on issues covered by the fee-shifting clause. In Sparton Corporation v. O’Neil, C.A. No. 12403-VCMR (Del. Ch. June 18, 2018), the court addressed that fee issue and some related issues in connection with a motion for judgment on the pleadings.

For busy readers who want to know the key issues addressed by the court, and refer to the referenced pages of the decision for more details and descriptions of the factual and legal issues addressed, I will cover several of the more noteworthy parts of the opinion in bullet points:

  • The court describes the heightened requirements for issuing a mandatory injunction, which are more stringent than the prerequisites for a more conventional preliminary injunction. See page 10.
  • The court discusses basis contract interpretation principles at pages 5 and 6.
  • The court discusses the standard for a motion for judgment on the pleadings, pursuant to Rule 12(c), at page 4.
  • The court determined that it did have equitable jurisdiction to rule on a request for specific performance to order an escrow agent to release escrow funds. See footnote 32. (There is some case law, based on different facts, that reached a different conclusion: that a request for monetary relief, including funds held in escrow, is a request for a legal remedy that is outside the equitable jurisdiction of the court.)
  • The court analyzed the request for interim fees based on a fee-shifting contract provision and explained its rationale for why the claims covered by the contract clause would be the basis for an interim award of fees. See pages 13 to 16.
  • The court also addressed the issue of whether the fees were reasonable and notably, determined that pre-litigation research and analysis was covered by the contractual fee-shifting clause awarding fees to the prevailing party, and that those fees also met the test of reasonableness. See pages 16 to 22. See also footnote 54 for a reference to Delaware’s “pizza theory” of fee challenges.

Court of Chancery Has Power to Issue Bench Warrant for Violation of Court Order

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

Chancery Describes Fiduciary Duty of Loyalty and Remedies Available for Breach

The Delaware Court of Chancery in a recent opinion reiterated the definition of the fiduciary duty of loyalty and explained the flexibility that it has as a court of equity in fashioning a remedy for the breach of that duty. In CertiSign Holding, Inc. v. Kulikovsky, C.A. No. 12055-JRS (Del. Ch. June 7, 2018), the court addressed several issues in connection with claims and counterclaims involving a complex web of inter-related companies and business relationships.  The court provides a graphic chart which described how the 12 entities involved were inter-related.  Among the claims described in this 83-page opinion were breaches of the fiduciary duty of loyalty by refusing to cooperate to correct corporate records for solely personal reasons, as well as related claims.

For purposes of this short blog post, I will focus on the statements of law that will have the most wide-ranging applicability instead of focusing on the very extensive factual allegations.

Additional background facts are contained in a prior decision in this case pursuant to DGCL Section 205 in which the court entered an order validating the outstanding stock and proffered stock ledger to fix the problem arising out of the issuance of capital stock that was not properly approved. See In Re CertiSign Hldg., Inc., 2015 WL 5136226 (Del. Ch. Aug. 31, 2015).

Part of the allegations for breach of fiduciary duty of loyalty arose out of the defendant director’s refusal to agree to cooperate to correct the defect in the corporate records without the company first agreeing to grant a personal benefit to that defendant director.

Key Statements of Law:

Although well-defined and well-established, it remains helpful to review an articulation of the bedrock fiduciary duty of loyalty owed by directors of Delaware companies. The court described the duty of loyalty as follows:

  • “A public policy, existing through the years . . . demands of a corporate officer or director, peremptorily and inexorably, the most scrupulous observance of the duty, not only affirmatively to protect the interests of the corporation committed to his charge, but also to refrain from doing anything that would work injury to the corporation.” Slip op. at 43. See also footnotes 183 and 184.  (citing cases that found a breach of the duty of loyalty when a controlling stockholder implemented an interested transaction that was designed to protect the personal interests of the directors and was not reasonably or necessarily related to the best interests of the corporation.)

In the instant case, the court explained that the duty of loyalty was breached because the defendant director refused to cooperate with the attempt to correct the corporate records—and that refusal jeopardized the existence and operations of the company solely in order to obtain leverage to advance personal interests.

The court also explained that, as a court of equity, it has flexibility to award damages for breach of the duty of loyalty that allows the relaxation of the usual requirement of a connection between causation and the damages resulting from the breach. See Slip op. at 76 and 77. See also footnotes 274 through 277.  In particular, the court explained that “concerns of equity and deterrence justify loosening normally stringent requirements of causation and damages when a breach of the duty of loyalty is shown.”

The court granted attorneys’ fees incurred by the company to correct defective records that the defendant director refused to cooperate to fix as the remedy for breach of fiduciary duty (as opposed to awarding fees for bad faith litigation, for example, which was not the basis for the award in this case). See footnote 287.

Court Explains When Dual Claims for Breach of Fiduciary Duty and Breach of Contract Can Be Pursued

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.”

Recent Delaware LLC Law Scholarship

A recent law review article provides excellent scholarly insights regarding the interface among the equitable powers of the Court of Chancery and the provisions of the Delaware LLC Act and LLC operating agreements. The article by Professor Mohsen Manesh entitled: “Creature of Contract: a Half-Truth About LLCs,” appears in Volume 42 of the Delaware Journal of Corporate Law (that recently arrived in the mail.)  An example of why this article should be read by anyone who litigates issues involving breaches of an LLC agreement and the potential applicability of equitable remedies, is the section beginning at page 453 of the article which includes the heading:  “Judicial Power to Disregard LLC Agreements,” and includes copious citations to case law and other sources.

Chancery Defines Key Principles of Corporate Litigation

A recent decision of the Delaware Court of Chancery provides useful definitions and explanations for well-established principles applicable to corporate litigation. The opinion in Steinberg v. Bearden, C.A. No. 2017-0286-AGB (Del. Ch. May 30, 2018), involves claims that a board of directors and two of its officers breached their fiduciary duties by making or permitting to be made several materially false and misleading statements about the financial condition of the company.

In connection with dismissing the claims, the court reiterates several basic principles and explains definitions of key terms and standards applicable to stockholder derivative suits.  For example:

  • The court explains the different circumstances in which the Aronson test will be used to analyze demand futility as compared with situations when the Rales test will be used. See pages 15 and 16.
  • The court provides a definition of bad faith to be used when a non-exculpated claim for breach of the duty of loyalty is alleged. See page 21.
  • The court provides an always useful definition of  the standards of “interested” and “independent” for purposes of determining if directors are disabled from considering a pre-suit demand. See pages 19 and 20.
  • The court defines the duty of disclosure owed by officers and directors even when no stockholder action is requested. See page 22.

In sum, the court granted a motion to dismiss for failure to establish pre-suit demand futility in connection with allegations of false and misleading statements