Paron Capital Management LLC v. Crombie, C.A. No. 6380-VCP (Del. Ch. May 22, 2012).
Issue Addressed: Whether the breach of fiduciary duty owed by a hedge fund manager to his partners entitles them to lost future earnings.
Short Answer: The Court found that the partners who were defrauded were entitled to lost future earnings and other costs associated with the formation and operation of a hedge fund that they were misled into joining based on false statements. The Court also awarded plaintiffs injunctive relief requiring one of the founders of the hedge fund to destroy or return copies of the trading program used by the hedge fund.
This case was brought by two partners in a hedge fund, McConnon and Lyons, who were fraudulently induced to participate in the founding of Paron Capital Management LLC by James D. Crombie, the sole defendant in this action. Crombie was pro se and did not appear at trial. In this post-trial opinion, the Court found that Crombie developed the futures trading program around which Paron was founded but the trading program developed to trade futures contracts was a fraud. The Court found after trial that Crombie misled McConnon and Lyons to form the LLC to manage a hedge fund product and client accounts using his futures trading program.
McConnon was formally a principal of a multi-billion dollar hedge fund based in London, and Lyons had worked as a senior investment professional before they formed Paron.
Despite extensive due diligence that the Court described as including a formal investigation and report by the international risk consulting firm, Kroll, Inc., and which also included a credit history, property records and employment history, the Kroll report “failed to raise any red flags about Crombie’s history or personal situation.” The opinion describes a veritable tale of woe. The ownership of Paron was structured to give Crombie a 75% ownership interest, McConnon a 20% interest and Lyons a 5% interest.
Procedurally, prior to the instant case, the plaintiffs filed a declaratory relief action requesting the removal of Paron as a manager pursuant to Sections 18-110 and 18-111 of the Delaware LLC Act, at Title 6 of the Delaware Code.
This action was subsequently filed the next day, on April 14, 2011, alleging fraud and breach of fiduciary duty. The trial was on October 3 through 5 of 2011 at which Crombie failed to appear. He filed for bankruptcy in February 2012 which stayed this action, but pursuant to a motion, the stay was lifted in February of 2012. [An attorney for the plaintiffs was quoted as saying that judgments for fraud are not discharged in bankruptcy.]
In its description of the elements that need to be proved by a preponderance of the evidence to establish fraud, the Court explained that: “Fraud need not take the form of an overt misrepresentation; it also may occur through concealment of material facts, or by silence when there is a duty to speak.” The Court found that plaintiffs proved by a preponderance of the evidence that Crombie committed fraud against them. The Court described in detail the fraudulent account documentation that constituted false representations of fact that Crombie made to the plaintiffs. The Court explained the reasonableness of the reliance by plaintiffs on the misrepresentations, including a description of the extensive due diligence that they performed.
The Court also described the breach of the traditional duties of loyalty and care. See fn. 22 (citing caselaw for the statement of Delaware law that: “In the absence of a contrary provision in the LLC Agreement, LLC managers and members owe traditional fiduciary duties of loyalty and care to each other and to the company.”) The Court observed that: “A director will breach his fiduciary duty of loyalty where he knowingly disseminates false information that results in corporate injury or damage to an individual stockholder.” See fn. 25.
Plaintiffs claimed that the full extent of their injuries resulting from the fraud and breach of fiduciary duty by Crombie was at least $44 million in the form of reliance damages, mitigation damages and lost earnings. The majority of this amount resulted from the lost earnings of McConnon. The Court awarded over $700,000 for reliance damages that included the due diligence investigation, legal expenses related to the loans made to Paron, travel expenses, legal and accounting fees related to the formation of Paron and related costs.
The Court also awarded litigation costs for damages related to the legal fees, expert costs and other costs incurred to mitigate the damage caused by the fraud of Crombie such as legal fees incurred in connection with regulatory proceedings against Paron and Crombie and foreclosing on collateral provided by Crombie for the loan involved.
Legal Expenses as Form of Damages
The Court cited to Restatement (Second) of Torts § 914 (1979), as an exception to the American Rule that allows recoupment where legal expenses were incurred as a direct consequence of fraudulent conduct. At footnote 29, the Court cited to a Delaware decision which explained as follows:
“Whether characterized as an exception to the American Rule or as a rule in its own right, Section 914(2) of the Restatement, (Second) Torts, allows for the recovery of legal fees and costs from an earlier action where: one who through the tort of another has been required to act in the protection of his own interest in bringing or defending an action against a third person . . .”
The Court, based on the foregoing analysis, granted mitigation damages of $752,133.
The largest portion of the award was based on lost future earnings that resulted from the stigma that was imposed on the plaintiffs and the ruination of their prospects for future employment in the financial services industry as a result of their association with Crombie, and the damage to relationships with their clients which effectively made them unemployable in their industry.
The Court relied on the testimony of the principal of an expert professional search firm as well as an analysis about future lost earnings by a certified public accountant. The Court accepted testimony that McConnon would likely have been able to receive annual compensation between $3 million and $5 million per year but that as a result of him being tainted by association with the defendant, the expert testified that he could probably not find work that would pay him more than $300,000 per year. As a result of the testimony, the Court awarded McConnon damages for lost earnings in the amount of $32,160,816. The other plaintiff, Lyons, was awarded lost earnings of $1,892,305.
This case is noteworthy for several reasons. One is the rather unusual award in Chancery cases of “future lost earnings.” The other noteworthy aspect of damages in this case is that legal expenses were awarded as a result of expenditures that were necessary to protect the plaintiffs due to the fraud of the defendant – – and not for the usual reasons such as the “bad faith exception to the American Rule.”