Latesco, L.P. v. Wayport, Inc., Del. Ch., No. 4167-VCL (July 24, 2009),  read opinion here.


This 26-page  Chancery Court opinion involves the efforts of a shareholder to monetize a part of his illiquid, minority interest in a private company he co-founded, but in which he was no longer an insider.  His sales of stock were governed by an agreement to give the corporation and certain insiders the right of first refusal.  In a second transaction, however, the stockholder was asked, and agreed, to sell more shares than originally negotiated with a third party.  That is, those shares were outside the agreement.

The stockholder claims that “in deciding whether or not to exercise the right of first refusal and in requesting that extra shares be made available for purchase, the corporate insiders should have but did not disclose the assets sale” that the insiders allegedly knew about when they purchased his shares.

Overview of Holding

The court recognized that:

“the performance of a Stockholder Agreement giving corporations or corporate insiders rights of first refusal over the shares of other stockholders is not governed by any generalized fiduciary duty of disclosure nor is it governed by any generalized application of the duty of loyalty.  Instead, the contours of such an insider’s duty to the selling stockholder is defined by the terms of the agreement itself and the normal prohibitions against fraud.  In contrast, where transactions are made outside the confines of such an agreement, insiders should expect to observe the normal obligations of fiduciaries not to engage in transactions with stockholders while in the possession of material information known to be available to the sellers.” (emphasis added).

Key Facts

The key facts at this motion to dismiss stage of the proceedings, as described by the court, include the observation that the conduct of the defendant insiders did not fall entirely within the scope of the right of first refusal agreement.  Instead, the court found that there were well pleaded allegations of fact that a sale of stock involved more than that contemplated by the terms of the agreement between the parties.  Specifically, the corporation asked the stockholder to make a large number of additional shares available for sale beyond those for which they had any right of first refusal.  Because the sale of those shares was outside of the analytical framework of the right of first refusal agreement, the court decided this motion to dismiss based on the normal standard of fraud, as applied to transactions between “corporate insiders” and minority stockholders. 

In footnote 16, the court defined “insider” for purposes of this opinion as a “stockholder-party that, by virtue of board representation or observers, possesses additional information about the fortunes of the company beyond that generally made available by corporate management to the stockholders.”

Standards Applied

The court explained that the applicable standard of fraud in this case is a “scienter-based standard that, in the case of a fiduciary, may include a duty to speak when, in purchasing or selling stock, a fiduciary is aware that material information is known to him but not to the counter party to the transaction.”  See footnote 17 for cases cited.

The court emphasized that:

“This standard is not an instance of the fiduciary duty of disclosure that results from a call for stockholder action.  The rule requiring calls for stockholder action to be accompanied by full and fair disclosure of all material information regarding the decision presented to the stockholders is premised on the collective action problem that stockholders, in the aggregate, are faced with when asked to vote or tender their shares.” See footnote 18.

The court explained that the general fraud standard that the court applied was not directly derived from the fiduciary duty of loyalty nor was it the same as a fiduciary insider trading claim pursuant to the decision in Brophy v. Cities Service Co., 70 A.2d 5 (Del. Ch. 1949).  The court distinguished a Brophy claim as being fundamentally derivative in nature because it arises “out of the misuse of corporate property – that is, confidential information – by a fiduciary of the corporation, for the benefit of the fiduciary and to the detriment of the corporation.

Issue Raised

In the instant case however, the court framed the precise question presented thusly:

“If the court were to ignore the extra shares or otherwise regard the second sales transactions as governed by the contract, the question then becomes what, if any, disclosures was an insider who was a party to a right of first refusal agreement  required to make to an outsider when exercising such a right.  This appears to be a matter of first impression both in Delaware courts, and, to the best of the court’s research, elsewhere.  Courts have addressed a similar, not entirely analogous, issue that arises when corporations act to exercise contractual repurchase rights triggered by death or termination of employment but it is hard to discern any general rule.”  (emphasis added.) See footnote 24 for cases cited and distinguished.

Contract v. Fiduciary Analysis

 Moreover, the court expanded on the nuances involved with a right of first refusal argument:
“Many factors beyond the mere existence of a contract distinguish the exercise of a right of first refusal from situations in which the law imposes a strict fiduciary fidelity.  First, it must be said that the exercise of a right of first refusal does not involve the fiduciary in soliciting sales or even offers to sell; on the contrary, the impetus for the transaction comes from the selling stockholder who has already arranged a separate sale requiring performance under the right of first refusal.  Second, the fiduciary is not involved in any price negotiation with the selling stockholder; instead the pertinent price negotiation is between the selling stockholder and the purchaser.  Third, as is true in this case, the selling stockholder often signs a right of first refusal agreement that contains no contractual right to information; thus, he has reason to know that any decision he makes to sell once he is no longer an insider will be made without access to the broad scope of information available to insiders.  These factors all suggest the justice of enforcing a right of first refusal according to its terms.”
Applicable Fiduciary Duty and Fraud Standards
The court clarified that the request by the corporation to buy extra shares from the shareholder “is presumed, for current purposes [on a motion to dismiss], to distinguish the case from one involving purely contract issues", inhabiting as it does the intersection of contract, fiduciary duty, and fraud.
Thus, although the court dismissed what it described as the “breach of fiduciary duty of disclosure claim,” it added that: 
“with respect to the duty of loyalty, for the purposes of the motions to dismiss, the complaint pleads sufficient facts to support a claim that Trellis and NEA traded with Stewart in the second sales transaction while in the possession of undisclosed material inside information.  Because the second sales transactions are not well cabined within the four corners of the Agreement, general fiduciary principles apply” (emphasis added).
The court also recited the elements of a claim for fraud or fraudulent misrepresentation and noted that “positive misrepresentation is not required.”  Rather, the court explained that a claim of common law fraud can arise from three types of conduct:
“(1) A representation of false statements as true;
 (2) Active concealment of facts that prevents their discovery; or
 (3) Remaining silent in the face of a duty to speak.”  See footnote 29 for cited cases.
The court determined that there was no “duty of disclosure” under which the corporation or its directors were bound to provide full and fair information to the selling stockholder – plaintiff.  However, because the court found that the complaint did succeed in stating a claim for a “breach of the duty of loyalty,” the defendants, ruled the court, “can be said for the purposes of these motions to have been subject to a duty to speak which made silence about the material inside information they possessed impermissible.” (emphasis added).
In addition, the court reasoned that:  “with respect to the third element of common law fraud, it is clear from the pleadings what the plaintiffs alleged the defendants sought to induce them to do – – to sell at a lower price than they otherwise would have if apprised of the facts which the defendants failed to disclose.”
Also quite instructive is the clarification in footnote 33 that distinguishes between a contractual right to information and a statutory right of a stockholder to data about the company.  The court noted that:
“Absent contractual information rights, the stockholder must rely on 8 Del. C. Section 220 as a basis for rights to certain information.  The covenant of good faith and fair dealing does not expand those rights.  Rather, the court has explicitly held above that if the second sales transaction had fallen within the four corners of the Agreement, the only claim that could lie against any of the defendants would be affirmative fraud – – that is, fraud involving an actual misrepresentation or active concealment of facts” (emphasis in original).

POSTSCRIPT: A subsequent decision from California involving a similar issue but based on much different facts, rendered on Jan. 6, 2010, by the Fourth Appellate District, Division Three, styled Le v. Pham, is available here.