Xu  v. Heckmann Corporation,  No. 4673-CC (Del. Ch. October 26, 2009), read opinion here.

The Chancellor of the Delaware Court of Chancery in this opinion decides a Motion to Dismiss Counterclaims involving issues related to fraud allegations against a director. The founder of a selling company, based in China, became a director of a U.S. corporate buyer as part of the deal. It was in this context that claims against the director were made post-closing by the purchaser. Similarly, the purchaser claimed that the fraud of the seller should relieve it of any duty to fulfill the payment obligations of the deal.

(The Court of Chancery Courthouse in Georgetown, Delaware, is featured in the photo).

The factual background involved a purchase via merger by the Heckmann Corporation of a bottled water producer and distributor in China, founded by Xu Hong Bin, a citizen of the People’s Republic of China. The purchase price included $15 million in cash, the right to contingent payments of an additional $15 million, as well as restricted shares in the Heckmann Corporation. The merger also included Xu continuing as the president of China Water and also becoming a director of Heckmann. As a result of post-closing issues that developed, the parties entered into an Escrow Resolution and Transition Agreement (“ERTA”) which required the restricted shares that were part of the Merger Agreement to be returned to Heckmann at a substantially discounted price. The ERTA included a broadly worded mutual release of claims between Xu and Heckmann, as well as an integration clause.

Overview of Claims and Counterclaims
Xu sued for specific performance of the ERTA. Heckmann filed counterclaims claiming that Xu breached fiduciary duties he owed to Heckmann as a director and that he also breached the ERTA. Heckmann also asserted that Xu is not entitled to certain payments already made to him. The Court noted that Heckmann asserted that it was fraudulently induced into signing the ERTA by Xu’s failure to disclose fraudulent conduct, which was technically not a counterclaim, but rather was an affirmative defense to enforcement of the ERTA.

There are many detailed factual allegations that are beyond the scope of this short blog overview, but in essence, they involve what Heckmann alleges to be substantial fraud that it only discovered after the closing. The broad release language in the ERTA (which was entered into after the merger agreement), was the principle basis for the Plaintiffs’ Motion to Dismiss the Counterclaims filed by Heckmann. The choice of law provision in the ERTA provided that “except to the extent that the corporate laws of the State of Delaware apply to a party, this Agreement shall be governed by the laws of the State of New York." Thus the fiduciary duties owed by Xu to Heckmann were governed by Delaware law while general contract duties were governed by New York law.

Discussion of Scope and Validity of Release

The general release language in the ERTA covered claims being released between Xu and Heckmann and also included those  claims: “whether known to Heckmann or China Water at the time of execution of this Agreement or not . . ..”

Heckmann argued that the general release language was not valid because the transaction was “self interested” to the extent that it would purport to protect Xu from claims by Heckmann after Heckmann discovered the fraudulent conduct of Xu. See cases cited in footnotes 15 through 18.
The Court agreed that if Heckmann was unaware of the fraud committed by Xu when he negotiated the ERTA, while Xu was a director, then Xu “clearly had a fiduciary duty to inform Heckmann that the release would cover his alleged fraudulent conduct because the information would have been material to Heckmann’s decision to enter into the ERTA.” See footnote 20. The Court reasoned that such a rule:

“simply follows general principles of Delaware law that require a director to make full disclosure of his interest in the transaction before engaging in that transaction with the corporation. If the corporation is unaware that it is releasing a director of potentially fraudulent conduct then it is unaware of the director’s existing personal interest in the release.”

However, the Court highlighted an important distinction in a situation where a director negotiates a general release with his corporation made amidst corporate “suspicions or allegations that the director committed fraud” and where the mutual release is intended to settle those fraud claims, "even if the full scope of those claims is unknown when the release is signed.”

In such circumstances, the director accused of fraud does not have a fiduciary duty to disclose all his wrongful acts prior to signing a release. In such a situation, if the corporation already suspects fraud has occurred, and it settles the claims against the director with a general release, it cannot be said that the corporation was deprived of material information it needed to evaluate the settling of its claims. This is so because the corporation would be aware that a director has an existing personal interest in the transaction (i.e., the release agreement), and is aware that fraud may be greater than it suspects. See footnotes 21 through 24.

The Court recognized that the distinction makes sense because requiring a director accused of fraud by his corporation to disclose all prior wrongdoing before negotiating a settlement would make the settlement of fiduciary claims arising out of fraudulent conduct impossible. Requiring a full confession, especially as to disputed claims, would remove any incentive to settle and would remove any assurance that upon hearing of additional wrongdoing, that the corporation would still settle.

There was a factual issue here about whether Heckmann was aware of fraud or of potential fraud committed by Xu when it entered into the release and that factual issue could not be resolved at this early procedural stage.

The Court related the foregoing analysis to the fraudulent inducement arguments which were considered as an affirmative defense and not regarded by the Court as a counterclaim. That affirmative defense to the formation of a contract was controlled by agreement pursuant to New York law.

Breach of Contract Claim Dismissed

There was an issue about whether Xu had the authority to enter into the ERTA. The Court observed that

“all contracts include the inherent representation that the party entering into the contract has the authority to do so. This inherent representation is important because, if it is false, the contract may fail or be unenforceable as a matter of law. Thus, if a person signing a contract misrepresents that he has the necessary authority to do so, the legal questions that are triggered have to do with contract formation or enforceability, not breach of contract.”

The Court explained why this makes sense as a matter of logic. In this case, Heckmann wanted to prove that Xu lacked authority to enter the ERTA. If Xu lacked the authority to enter into the ERTA, then that lack of authority was not a breach of contract, because the contract would not exist or would not be enforceable by virtue of that lack of authority. Thus, the Motion to Dismiss the Counterclaim for Breach of Contract was granted.

Claim for Conversion Rejected

In Delaware, “an action in conversion will not lie to enforce a claim for the payment of money.” See footnote 44. No exception to that rule applied here because Heckmann was suing for a return of money pursuant to a disputed contract and those claims would be based on contract principles. Thus, the Motion to Dismiss the Counterclaim for Conversion was granted. See also footnote 47. (In order to assert a tort claim along with a contract claim, the plaintiff must generally allege that defendant violated an independent legal duty, apart from the duty imposed by contract.)