Mickman v. American International Processing, L.L.C., et al,  (Del. Ch., C. A. No. 3869-VCP, April 1, 2009),  read opinion here.

Kevin Brady, a highly respected Delaware litigator, provides us with the benefit of his analysis of this case.

In this Chancery Court decision, Vice Chancellor Parsons addressed the issue of what evidence the Court might would consider in determining who had standing under 6 Del. C. § 18-305 to inspect the books and records of a Delaware limited liability company.

No Evidence of Membership in Operating Agreement

Defendant LFF, L.L.C. (“LFF”) moved for summary judgment on the basis that plaintiff was not entitled to inspect the books and records of LFF because she was not a member or manager of LFF. Defendant LFF argued that there was no record evidence in the company’s documents to show that plaintiff had any interest in LFF. Plaintiff responded by referring to documents signed by Richard Mickman (plaintiff’s ex-husband) and Howard Gleit, the only two members of LFF listed in the LLC operating agreement initially. In particular, plaintiff identified a 2001 tax return for LFF, which in the Schedule K-1 for each member, listed the members as Howard Gleit and [plaintiff and her ex-husband]. In addition, before they were divorced, plaintiff’s ex-husband “signed under penalty of perjury an Offer in Compromise to the IRS on or about February 9, 2002, in which he stated that his ‘only assets are his house . . . and stock in a number of closely held companies owned jointly by Taxpayer and his wife.’ ”

Should LLCs Get the Same Treatment as Corporations?

Under 6 Del. C. § 18-305, “[e]ach member of a limited liability company has the
right . . . to obtain from the limited liability company from time to time upon reasonable
demand for any purpose reasonably related to the member’s interest as a member of the
[LLC] . . . [various records of the LLC].” LFF argued that it had a formal operating agreement and that neither that agreement nor any amendments to it listed plaintiff as a member of LFF. LFF also argued that the Court should treat an LLC like a corporation in connection with a demand for inspection of books and records. For a corporation, only stockholders listed in the stock ledger are recognized as holders of record of stock for purposes of a request for books and records under Section 220 of the Delaware General Corporation Law. LFF argued that the Court should extend that reasoning to LLCs such that “only members listed in an LLC’s operating agreement, where a written agreement exists, should be recognized as members with a right to inspect books and records under Section 18-305.”

To support its argument, LFF cited Shaw v. Agri-Mark, Inc., 663 A.2d 464 (Del. 1995), where the Delaware Supreme held that “a party who supplied equity to a stock corporation, but who was not a stockholder of record, had no right to inspect the corporation’s books and records under Delaware common law or under Section 220.”

Vice Chancellor Parsons concluded, however, that there was nothing in that case to suggest, “by analogy or otherwise, that the inspection rights of members of an LLC under Section 18-305 should be limited strictly to persons named as members in the operating agreement.” (citing the decision in Shaw where Court limited the holding to stock corporations.)

Evidence Outside the Operating Agreement Considered?

Vice Chancellor Parsons stated that “LLCs generally are created on a less
formal basis than corporations and are basically creatures of contract.” Based on the
flexible and less formal nature of LLCs, the Court noted that “it is reasonable to consider evidence beyond the four corners of the operating agreement, where, as here, the plaintiff has presented admissible evidence that, notwithstanding the language of the operating agreement, that suggests the parties to the agreement intended to make, and believed they had made, the plaintiff a member of the LLC.”

Summary Judgment Denied

While there was no dispute that the LFF operating agreement did not list plaintiff as a member, there was evidence that the representations about plaintiff’s membership were mistakes. As a result, the Court denied LFF’s motion for summary judgment.
 

16th Annual Review of Key Delaware Corporate and Commercial Decisions

By: Francis G.X. Pileggi and Chauna A. Abner

This is the 16th year that Francis Pileggi has published an annual list of key corporate and commercial decisions of the Delaware Supreme Court and the Delaware Court of Chancery. This list does not attempt to include all important decisions of those two courts that were rendered in 2020. Instead, this list highlights notable decisions that should be of widespread interest to those who work in the corporate and commercial litigation field or who follow the latest developments in this area of Delaware law. Prior annual reviews are available here.

The Delaware Business Court Insider again published this year’s Annual Review though it appeared in two parts due to its length, in last week’s edition and in this week’s edition. Part I and Part II are reprinted below with the courtesy of The Delaware Business Court Insider. (c) 2020 ALM Media Properties, LLC. All rights reserved.

This year’s list focuses, with some exceptions, on the unsung heroes among the many decisions that have not already been widely discussed by the mainstream press or legal trade publications. For example, the Sciabacucchi; Solera; and AB Stable (Anbang) cases have already been the subject of extensive commentary by others. Links are also provided below to the actual court decisions and longer summaries.

DELAWARE SUPREME COURT DECISIONS

Supreme Court Instructs on Nuances of Fiduciary Duties of Disclosure and Loyalty

A Delaware Supreme Court decision from 2020 that deserves to be read by anyone interested in the nuances of Delaware law on the fiduciary duties of disclosure and loyalty of a manager or a director in connection with communications with stockholders or others to whom a fiduciary duty is owed, is Dohmen v. Goodman, No. 403, 2019 (Del. June 23, 2020), in which Delaware’s High Court answered a question on this topic certified from the U.S. Court of Appeals for the Ninth Circuit.

Key Takeaways:

There is a “per se damages rule” in Delaware that covers only those breaches of the fiduciary duty of disclosure involving requests for stockholder action that impair the economic or voting rights of investors. Importantly, this per se damages rule only covers nominal damages. Again, for emphasis: the per se damages rule does not apply to damages other than nominal damages. Therefore, in order to recover compensatory damages, one who proves a breach of the fiduciary duty of disclosure must also prove reliance, causation and damages. See Slip op. at 24.

The Court in its en banc opinion provides a useful overview of fiduciary duties in general, and addresses the many nuances–that change depending on the situation presented–of the duty of disclosure in particular as it relates to requests for action by stockholders or others to whom a fiduciary duty is owed.  See Slip op. at 9-10.

Brief Overview of the Case:

The procedural background of the case involved an issue of Delaware law that the U.S. Court of Appeals for the Ninth Circuit certified to the Delaware Supreme Court. In other words, the Ninth Circuit asked the Delaware Supreme Court to decide an issue of Delaware law that was originally presented to the Ninth Circuit.

This gem of a 24-page opinion, which is relatively short for many Delaware opinions, was decided based on stipulated facts, which in a very simplified way, decided a claim by a limited partner in a hedge fund, who as limited partner in a limited partnership was owed a duty by the fund manager, which was structured as an LLC. Among the claims by the limited partner was that the general partner of the limited partnership, the LLC manager, breached fiduciary duties by failing to disclose that the general partner was the only investor in the fund other than the suing limited partner, and related omissions or misrepresentations.

Delaware Fiduciary Duty Law:

In connection with its decision, the Delaware Supreme Court recited several useful truisms of Delaware law. For example, the agreements at issue did not disclaim the fiduciary duty of loyalty, and therefore, the general partner owed fiduciary duties to the limited partners, similar to those owed by directors of Delaware corporations. See footnotes 15 through 16.

The Court recited the very nuanced and multifaceted aspects of the fiduciary duties of care and loyalty that applied to communications with stockholders or limited partners. Those duties depend on the context of the communication, and whether the communication is to an individual stockholder or to a group of stockholders. See footnotes 18 through 32 and accompanying text.

The Court described several different types of factual situations which impact the application of the duty owed in connection with communications that involve a request for stockholder action, as compared to those that might involve merely periodic financial disclosures. The per se damages rule does not apply to the latter.

The Court discussed the most important Delaware decisions involving the duty of disclosure and how it is applied in various factual circumstances.

Bottom Line:

The Court explained that the per se damages rule only applies when a director seeks stockholder action and breaches their fiduciary duty of disclosure, in which case a stockholder may seek equitable relief or damages. That is, when directors seek stockholder action, and the directors fail to disclosure material facts bearing on that decision, a beneficiary need not demonstrate other elements of proof, such as reliance, causation or damages. This rule only applies to nominal damages and does not extend to compensatory damages. See Slip op. at 10 through 11.

Link to original post on these pages about this case.

 

Supreme Court Interprets Key Words in Agreement

A Delaware Supreme Court decision from May 2020 is noteworthy for the approach it takes in determining the meaning of a word in an agreement, for example, by parsing the syntax and sentence structure where the word at issue appears in the agreement. In Borealis Power Holdings Inc. v. Hunt Strategic Utility Investment, L.L.C., No. 68, 2020 (Del. May 22, 2020), the Delaware Supreme Court provides useful guidance about how to determine the meaning of a key word in an agreement. In this matter, despite a lengthy definition in the agreement of the word “transfer”, the parties still disputed its meaning.

Background:

The underlying dispute involved a complex constellation of interrelated entities which the Court provided a graphic description of by way of a chart. The essential facts on which the dispute was based involved the interpretation of an LLC agreement which imposed restrictions on the transfer of LLC units and provided for the right of first refusal and other provisions triggered by a “transfer.” Several terms were defined in the agreement–with rather lengthy definitions–but the definitions did not provide sufficient clarity. The most consequential definition that was disputed was the meaning in the context of the agreement of the word “transfer.”

The problem presented to the Court of Chancery was whether the sale of an interest triggered either a right of first refusal and/or a right of first offer, and if both applied, which was to be given priority.

The Court of Chancery concluded that a sale by Hunt of its shares to Borealis would be a “transfer.” The Supreme Court had a different view.

The finding by the Court of Chancery that the purchase of Hunt’s shares constituted a transfer, triggered the requirement to offer the shares to Sempra. As a result of other consequences of that holding, the Court of Chancery found that Sempra was the only party with the right to purchase the Hunt shares, and entered judgment in favor of Sempra. This expedited appeal followed an expedited trial. It remains noteworthy that this opinion came only 30 days after the final submission of the appeal to the Supreme Court.

Analysis by the Supreme Court:

The Supreme Court held that the right of first refusal in Section 3.9 of the agreement at issue is only triggered by transfers by the Minority Member and its Permitted Transferees, and that Hunt is neither. Put another way, Delaware’s High Court held that the fact that the right of first refusal is only triggered by transfers by the Minority Member is dispositive in favor of Borealis, regardless of whether the Hunt Sale could be said to effect an indirect transfer.

One of the agreements involved was governed by New York law and one was governed by Delaware law–but the Court noted that the law of both states as it relates to contract interpretation in this case is the same. See footnote 22.

Two other footnotes contain important observations of Delaware law that are especially worth remembering:

(1) The management of an LLC is vested in proportion to the then-current percentage or other interest of members in the profits of the LLC owned by all the members, and “the decision of members owning more than 50% of the said percentage or other interest in the profits [is] controlling.” Footnote 27; see Section 18-402 of the Delaware LLC Act.

(2) Also noteworthy is the observation by the Court that an argument that was only raised in a footnote would justify “passing over it” because footnotes, according to Delaware Supreme Court Rules, “shall not be used for argument ordinarily included in the body of a brief.” Footnote 28. See Del. Sup. Ct. R. 14 (d)(iv).

The most noteworthy parts of this pithy 21-page decision are found in the last few pages which include the core of the Court’s reasoning.

In particular, the most memorable part of the Court’s reasoning is the parsing by the Court of the syntax and sentence structure of the agreement in order to interpret the meaning of a particular word in the agreement. The Court focuses on the “subject of the operative sentence” in Section 3.1, of which “the verb phrase ‘may only transfer’ serves as the predicate.” The Court further explains that the subject of the operative sentence is neither accidental nor unimportant because it is the same subject for which the verb phrase “intends to transfer” serves as the predicate in section 3.9.

The Court added that the subject, which is stated conjunctively, does not include Hunt. Therefore, the Court reasoned that it was unnecessary and inappropriate to parse the definition of transfer, as defined in the agreement, to determine the scope of Section 3.1 and Section 3.9, because: “the subjects of the opening sentences in both of those sections do that for us.” See Slip Op. at 20 – 21.

In sum:

Although the detailed factual background needs to be reviewed more closely in order to fully understand the Court’s reasoning, for anyone who wants to understand Delaware law regarding proper contract interpretation, and interpretation of the meaning of a word, even when it is defined in an agreement, this opinion is must-reading.

Link to original post.

 

Delaware Supreme Clarifies Contract-Based Right to Corporate Records

A Delaware Supreme Court opinion issued in July 2020 should be required reading for anyone interested in the latest iteration of Delaware law on the contract-based right to demand “books and records” in the alternative entity context. Delaware’s High Court ruled in Murfey v. WHC Ventures, LLC, No. 294, 2019 (Del. July 13, 2020), that the Court of Chancery erred by interjecting into a limited partnership agreement a statutory requirement from Section 17-805 of the Delaware LLC Act that did not appear in the parties’ agreement.

The great importance of this ruling can best be appreciated by emphasizing that the Court did not opine in any manner on the statutory requirements for demanding books and records of a business entity–about which we recently provided an overview of key decisions on this topic, with the title of: Demands for Corporate Documents Not for the Fainthearted.

We will add to that characterization of Delaware decisions interpreting statutory provisions for demanding corporate documents, a general observation based on the instant decision: Contract-based demands for books and records of business entities are not for the fainthearted either. A few reasons that support our observation include the following:

  • This Supreme Court decision features the en banc Justices split 3-2, along with a less-than-common reversal of a Chancery decision. So, that procedural note underscores that 6 of the best legal minds in Delaware (5 jurists on the high court and 1 in Chancery rendering opinions in this case) cannot find unanimity on this issue.
  • The original demand in this case was made on January 10, 2018. The Chancery complaint was filed in September 2018. Through no fault of the court system, this final decision on appeal came down on July 13, 2020. About 2 years is still lightening-fast for the period from filing a complaint to a final decision by a state’s highest court, but that still implies substantial legal fees and the need for financial and other types of stamina for someone who is serious about seeking corporate records.
  • Although this decision provides authoritative guidance on this nuance of Delaware business litigation, a careful parsing of the opinion still reveals a fertile field for indeterminacy–which makes it a challenge for the lawyers toiling in this vineyard who are trying to predict the outcome of this type of contract interpretation dispute–even if one need not be concerned with applying the multitude of court decisions applying the statutory provisions for inspection rights in this context.
  • We will end our introductory observations on a positive note: despite the plethora of case law interpreting the various statutory provisions for demanding books and records, such as Section 220 and Section 18-305, this decision is a welcome addition to the relatively few published Delaware opinions that address the purely contract-based right to books and records of an alternative entity.

Basic Factual Background:

Based on the assumption that readers of this post are familiar with the basics of Delaware law in this area, we are only highlighting the irreducible minimum amount of facts to provide context for the key legal principles announced.

This case followed a typical pattern. The company provided some documents initially, and at the time of trial the only issue was the very limited documents the company refused to produce.

Somewhat unusual was that only one specific type of document was the subject of the trial court decision and the appeal: the K-1 of the other limited partners in the limited partnership. Although the company allowed counsel for the plaintiff and the plaintiff’s valuation expert to review those K-1s, they refused to let the plaintiffs themselves review the K-1s of other limited partners–even subject to the common confidentiality agreement.

The limited partnership agreements involved allowed for a rather broad scope of documents to be demanded, including tax returns which were specifically listed as being subject to production. The company took the curious position that a K-1 (of other limited partners) was not part of the tax returns of the company–or at least not within the scope of documents they need to produce.

Primary Issue Addressed on Appeal:

Whether the Court of Chancery erred by injecting into the terms of the agreement that provided for a right to books and records–additional statutory prerequisites. Short answer: yes.

High Court’s Reasoning–Key Takeaways:

The majority opinion made quick work of dispensing with the defense that valuation was not a valid basis for requesting the disputed documents or that tax returns were not needed to complete a valuation. See, e.g., footnotes 65 and 66 as well as related text. More notably, the Court found that the statutory notion of a “proper purpose” was not applicable to contract-based demands. See, e.g., footnote 53 and accompanying text (quoting with approval prior decisions so holding.)

Also noteworthy is the Court’s reference to dictionary definitions of words, including prepositions, at issue in this case. See footnotes 32 and 33.

The Court reviewed many prior Delaware decisions that addressed when, if ever, it would be appropriate to infer words or conditions that do not appear in the terms of an agreement, such as statutory prerequisites. Slip op. at 18-25.

A key part of the Court’s reasoning was that: because the partnership agreements involved

… do not expressly condition the limited partner’s inspection rights on satisfying a “necessary and essential” condition [a statutory concept], and given the obvious importance of tax return and partnership capital contribution information to the Partnerships’ investors, as evidenced by the agreements, we are not persuaded that such a condition should be implied. Slip op. at 25.

The majority opinion’s “rebuttal” of the dissenting opinion deserves to be read in its entirety. Slip op. at 32 to 37. Two especially notable excerpts:

  • “The words ‘necessary and essential’ do not appear in the written agreements”. Slip op. at 35.
  • “… we also do not agree that the parties to a limited partnership agreement have to expressly disclaim any conditions applied in the Section 220 context (or the Section 17-305 context….)” Footnote 85.

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Supreme Court Rejects Two Common Defenses to Section 220 Demands

A recent decision from the Delaware Supreme Court provides hope to stockholders who seek to obtain corporate documents pursuant to Section 220 of the Delaware General Corporation Law to the extent that Delaware’s High Court removed two common defenses that companies use to oppose the production of corporate records to stockholders. In AmerisourceBergen Corporation v. Lebanon County Employees Retirement Fund, No. 60, 2020 (Del. Dec. 10, 2020), the two most important aspects of the ruling are that:

(i) A stockholder making a Section 220 demand need not demonstrate that the wrongdoing being investigated is “actionable;” and

(ii) When the purpose of a Section 220 demand is to investigate potential wrongdoing and mismanagement, the stockholder is not required to “specify the ends to which it might use” the corporate records requested (i.e., exactly what it will do with the documents it receives).

Over the last 15 years we have highlighted many of the frustrating aspects of decisions construing Section 220 to the extent that one needs stamina and economic fortitude to pursue what oftentimes is an unsatisfying result. See, e.g.,recent overview on this topic.

This decision should be in the toolbox of every corporate litigator not only because it announces a new path for Section 220 cases and reminds us of the basic prerequisites of the statute, but also in light of it partially overruling and distinguishing some prior cases. This opinion also confirms that several Chancery decisions that were not in harmony with this decision should no longer be followed.

Key Takeaways:

       One of the most important takeaways from this decision is that the Court clarified that when the purpose of a Section 220 demand is to investigate potential mismanagement, the stockholder is “not required to specify the ends to which it might use” the corporate documents requested.  See page 22.

       The second most important takeaway from this case is the Court’s holding that a stockholder pursuing a Section 220 demand need not demonstrate that the alleged wrongdoing is “actionable.” See page 25.

       The three prerequisites (not including the many nuances) for successfully pursuing a Section 220 demand to inspect a corporation’s books and records requires a stockholder to establish that: (1) such stockholder is actually a stockholder; (2) such stockholder has complied with Section 220 respecting the form and manner of making demand for inspection of such documents; and (3) the inspection such stockholder seeks is for a proper purpose. See pages 12-13.

       The Court recited the many examples of proper purposes that have been recognized to be reasonably related to the interest of the requesting stockholder. See footnote 30 for a lengthy list, which includes “to communicate with other stockholders in order to effectuate changes in management policies.”

       The Court reiterated the well-known requirement that when the proper purpose of a stockholder making a Section 220 demand is to investigate potential mismanagement, a stockholder needs to demonstrate “a credible basis” from which the court may infer that “there is possible mismanagement that would warrant more investigation.” See page 15.

       Although a credible basis of wrongdoing needs to be presented by a preponderance of the evidence to pursue the proper purpose of investigating potential wrongdoing, a company will not be permitted to mount a merits-based defense of such potential wrongdoing. See page 37.

       Moreover, while trying to harmonize prior decisions on these nuances, the Court observed that some of the decisions struck a discordant note. See footnote 109.

       The Court also affirmed the following two aspects of the Court of Chancery’s ruling: (1) regarding the scope of documents, the Court found that it was appropriate to include a requirement that the company produce officer-level materials and (2) the high Court found it was not an abuse of discretion to order a Rule 30(b)(6) deposition–because the company refused to describe the types and custodians of corporate records that it had in response to discovery requests. See pages 39 and 43.

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DELAWARE CHANCERY COURT DECISIONS

Chancery Provides Refreshing Section 220 Guidance

The Delaware Court of Chancery rendered a decision in November 2020 that belongs in the pantheon of noteworthy Court opinions addressing the nuances, first principles and practical challenges regarding Section 220 of the Delaware General Corporation Law. There are many decisions on this topic addressing the right of stockholders to demand inspection of corporate records, but few are as “blogworthy” as this decision in Pettry v. Gilead Sciences, Inc., C.A. No. 2020-0173-KSJM (Del. Ch. Nov. 24, 2020). Compare another pantheon-worthy Chancery decision earlier this year in AmerisourceBergen. See Lebanon Cnty. Emps. Ret. Fund v. AmerisourceBergen Corp., 2020 WL 132752 (Del. Ch. Jan. 13, 2020), which was affirmed by the Delaware Supreme Court.

Weighing in at 69-pages, this opinion’s length is indicative of the complexities of Section 220 that are belied by the apparent simplicity of the statute. Our favorite part of this decision is the acknowledgement that when pursuing the statutory rights that Section 220 appears to allow, one can easily be stymied by the gamesmanship of companies who can play a war of attrition, usually with impunity, in light of the asymmetrical economics involved. See Slip op. at 3-5 and footnote 6 (citing an article addressing the obstacles to pursuing Section 220 rights: James D. Cox, et al., The Paradox of Delaware’sTools at Hand Doctrine: An Empirical Investigation,” 75 Bus. Law. 2123, 2150 (2020)).

Similar observations about the practical hindrances, economic and otherwise, to utilizing Section 220 have often been the topic of blog posts over the last 15 years. See, e.g., recent blog post explaining that Section 220 cases are not for the fainthearted.

This Gilead case provides guidance on an important topic that warrants a very lengthy analysis. We provide highlights via bullet points, and then interested readers can click on the above link and read all 69-pages.

The bullet points that we find to have the most widespread applicability and importance are the following:

• The Court criticizes the trend in which companies often inappropriately litigate the underlying merits of a potential, future plenary suit as opposed to addressing whether the prerequisites have been met for a Section 220 demand, as well as the tendency of companies to otherwise prevent stockholders from using Section 220 as a “quick and easy pre-filing discovery tool.” Slip op. at 3-4.

• The Court provides many quotable explanations of the “credible basis” standard that must be satisfied in order to rely on the proper purpose of investigating suspected wrongdoing. The Court emphasizes that this “lowest possible burden of proof” does not require a stockholder to prove that any wrongdoing actually occurred; nor does it require a stockholder to show by a preponderance of the evidence that wrongdoing is even probable. Slip op. at 23, footnotes 103 and 104.

• Rather, the Court instructed that the recognized proper purpose for using Section 220 to investigate suspected wrongdoing is satisfied when there is a credible basis to suspect merely the “possibility” of wrongdoing. Id. at 24, n.106.

• The Court addresses the common tactic used by companies challenging a proper purpose when they assert that the “stated proper purpose is not the actual proper purpose for the demand.” This opinion teaches that in order to succeed in such a defense, the company must prove that the “plaintiff pursued its claim under false pretenses. Such a showing is fact intensive and difficult to establish.” See footnote 153 and accompanying text.

• The Court made quick work of dispensing with the issue of standing in Section 220 cases. The Court reasoned that the standing argument in this case was in reality a Potemkin Village (our words) for the company’s challenge to the viability of derivative claims that the plaintiffs might pursue in the future. Although the Court discussed standing under Section 220 in general, it also underscored that a Section 220 proceeding does not warrant a trial on the merits of underlying claims. Slip op. at 41–42.

• The Court instructed that generally Section 220 plaintiffs need not specify the “end-uses” of the data requested for their investigation. Slip op. at 49.

• The Court also provided helpful practical tips about the scope of production required once the preliminary prerequisites of Section 220 have been satisfied. The Court noted that in some instances the company will be required to provide more than simply formal board materials. See Slip op. at 51-54.

• The opinion acknowledged that in some instances after limited discovery in a Section 220 action, plaintiffs can refine their requests with greater precision and that in some cases the Court has asked the plaintiffs to streamline their requests. See Slip op. at 63.

• In response to the Court being vexed by the overly aggressive tactics of the company, the Court invited the plaintiff to “seek leave to move for fee shifting.” As one example of the Court’s observation that the company was taking positions for no apparent purpose other than obstructing the exercise of the statutory rights of the plaintiff, the Court noted that the company refused to produce even a single document before litigation commenced.

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Must-Read Chancery Decision for Buyers of Businesses Whose Value Depends on Retaining Customer Relationships

The Delaware Court of Chancery in August 2020 addressed the issue of whether a seller was liable for not disclosing the notification it received prior to closing that one or more key customers were terminating their relationship with the seller’s business. Swipe Acquisition Corporation v. Krauss, C.A. No. 2019-0509-PAF (Del. Ch. Aug. 25, 2020). The Court’s decision and other decisions cited below must be read by anyone who seeks a deep understanding of Delaware law on this topic.

Key Issue Addressed:

When will a fraud claim survive in connection with a purchase agreement that restricts claims for misrepresentations and limits claims for indemnification? In this case, most of the motion to dismiss was denied, but one of the reasons this decision is noteworthy is because it exposes the lack of a bright-line-rule on this issue when compared to other decisions addressing the same or similar issues–depending on the specific terms of the anti-reliance clause involved and the specific claims of fraudulent misrepresentations or omissions.

As an indication of how common this issue is, a few days before this ruling the Court of Chancery issued another decision that addressed the issue: Pilot Air Freight, LLC v. Manna Freight Systems, Inc., No. 2019-0992-VCS (Del. Ch. Sept. 18, 2020).

Key Facts of Swipe case:

This case involves a dispute over the lack of disclosure by the seller prior to closing when the seller learned that a key customer was claiming to terminate its business relationship even though the sales price was impacted by the existence of key customers. The sellers knew that if the buyers learned of the termination by the key customer involved that the deal might not close. See Slip op. at 8. Nonetheless, the sellers did not inform the buyers of the termination of the key customer at issue. Moreover, the sellers did not amend any of the financial information provided to the buyers, which had then become stale. Id. at 9. Based on weaker-than-expected performance before the closing, the buyers and the sellers did agree to reduce the purchase price even though the loss of the key customer was not disclosed.

Key Principles of Law with Widespread Applicability:

  • The Court cited to multiple cases to explain when an anti-reliance clause will not bar a fraud claim. See Slip op. at 28-29.
  • The Court also elucidates when a fraud claim and a contract claim will not be considered duplicative; when both can proceed at the preliminary stage of a case; and when a contract claim and a fraud claim will not be considered boot-strapped. See id. at 31-33.
  • The Court explained why duplicative claims may often survive at the motion to dismiss stage. See footnote 61 and accompanying text.
  • The Court explained the primacy of contract law in Delaware, and when parallel contract claims and breach of fiduciary duty claims may not proceed in tandem. See footnote 58 and accompanying text.

In addition to the cases cited above on the topic at hand, this decision should be compared with the Delaware Superior Court’s Infomedia decision that was issued just a few short weeks before this Chancery ruling. Of course, the exact terms of the applicable agreements and the detailed circumstances are often determinative, but in the unrelated Delaware Superior Court decision about a month earlier, the Court concluded that the failure to inform the sellers shortly before the execution of an asset purchase agreement that key customers intended to terminate their service contracts, even though written notice had not yet been received, would not be a sufficient basis for fraudulent misrepresentation claims due to anti-reliance provisions in an asset purchase agreement, thereby resulting in a grant of the motion to dismiss, based on the terms of the agreement involved in that case. See Infomedia Group Inc. v. Orange Health Solutions, Inc. (Del. Super. July 31, 2020).

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Chancery Determines Standard Applicable to Contested Transaction

The recent Delaware Court of Chancery decision in Salladay v. Lev, No. 2019-0048-SG (Del. Ch. Feb. 27, 2020), addressed the standards the Court may apply to review the conduct of directors in a contested transaction, and determined that the entire fairness standard applied, based on the facts of this case, resulting in a denial of a motion to dismiss.

Key Points:

This decision provides the latest iteration of Delaware law regarding the analyses the Court employs to review a challenged transaction to determine whether fiduciary duties were fulfilled.

In this case, the Court determined that the business judgment rule did not apply. The Court provides a practical, educational elucidation of why the efforts to “cleanse” the transaction did not revive the business judgment rule, in light of the failure to satisfy the prerequisites discussed in Corwin v. KKR Holdings, LLC, 125 A.3d 304 (Del. 2015); Kahn v. M & F Worldwide (MFW), 88 A.3d 635 (Del. 2014); and In re Trados, Inc. Shareholders Litigation (Trados II) 73 A.3d 17 (Del. Ch. 2013).

The Court also discusses the recent Delaware Supreme Court cases which clarified “where or when the line is drawn” for the “cleansing” criteria to be considered as being imposed “ab initio,” such that a deal will earn the deferential BJR review standard, in Flood v. Synutra International, Inc., 195 A.3d 754 (Del. 2018), as well as Olenik v. Lodzinski, 208 A.3d 704 (Del. 2019).

Link to original post.

 

Chancery Explains Proper Methods to Expand Board Size and to Fill Board Vacancies

A recent Delaware Court of Chancery decision provides a primer on the proper way to expand the size of a board of directors and the proper way to fill board vacancies, as well as explaining the difference between a de facto and a de jure director. See Stream TV Networks, Inc. v. SeeCubic, Inc., C.A. No. 2020-0310-JTL (Del. Ch. Dec. 8, 2020).

This opinion should be at the fingertips of every corporate litigator who is called upon to address whether:

(1) the size of a board of directors was properly expanded;

(2) director vacancies were properly filled; or

(3) whether the actions of a de facto board member were binding even if because of technical mistakes that director was not properly appointed such that she would qualify as a de jure director.

Many additional consequential statements of Delaware law with widespread utility are included in this consequential 52-page decision.

Highlights:

       The Court describes the well-known prerequisites for obtaining a preliminary objection. See page 16.

       The Court provides a tutorial, with copious citations to statutory and caselaw authority, to explain: (i) how to expand the size of the board of directors; (ii) who has the authority to expand the size of the board; (iii) how to fill vacancies on the board; and (iv) who is authorized to fill vacant board seats. See pages 17 to 20.

       This opinion features a maxim of equity that would be useful to have available when the situation calls for it: equity regards as done what ought to have been done. See page 20.

       The Court explained that only the charter or the bylaws can impose director qualifications, and in any event those qualifications must be reasonable. See page 21.

       The Court explained that a director could not agree to conditions of service as a board member that would be contrary to the exercise of the fiduciary duties of a director. See page 22.

       An always useful reminder of the three tiers of review of director decision-making are provided. Those three tiers are: (i) the business judgment rule; (ii) enhanced scrutiny; and (iii) entire fairness. See pages 50 to 51.

       In addition to explaining when those three tiers apply, the opinion also regales us with a classic recitation of the business judgment rule as the default standard:

” . . . the default standard of review is the business judgment rule, which presumes that in making a business decision the directors of a corporation acted on an informed basis, in good faith and in the honest belief that the action taken was in the best interest of the company.” See page 50.

      This decision teaches that unless one of the rule’s elements is rebutted, the Court merely looks to see whether the business decision made was rational in the sense of being one logical approach to advancing the corporation’s objective.

       The Court explains the difference between a de facto director and a de jure director, and which actions of a de facto director are binding.  See pages 23 to 25.

       Another extremely important aspect of this decision (which takes up the majority of the 50-plus pages) is a deep dive into the historical foundations of Section 271 of the Delaware General Corporation Law which applies generally to the sale of most or all of the assets of a corporation, and which would typically require stockholder approval. See page 27 through 48.

       The Court supports with detailed reasoning and extensive footnote support its conclusion that Section 271 does not apply to an insolvent corporation that transfers assets to a secured creditor. Compare DGCL Section 272 (allows directors to mortgage corporate assets).

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Delaware Court of Chancery Provides Rule 11 Insights

There are relatively few Chancery decisions on Rule 11 compared with more common corporate and commercial litigation issues that are the subject of Chancery opinions, and an October 2020 letter decision provides insights into why there are not more rulings on Rule 11. In POSCO Energy Co., Ltd. v. FuelCell Energy, Inc., Civil Action No. 2020-0713-MTZ (Del. Ch. Oct. 22, 2020), in which a motion for leave to amend under Rule 15 was granted without awarding fees, while distinguishing both the Lillis and Franklin Balance cases, the Court explained that Rule 11 should not be casually raised, but that in any event a requirement for invoking it is to provide separate written notice and an opportunity to cure, as opposed to including it as part of a motion addressing other issues as well.

The Court explained that:

FuelCell has invoked Court of Chancery Rule 11 casually and repeatedly in this matter.21 The Court may only determine if Rule 11(b) was violated “after notice and a reasonable opportunity to respond,” and a litigant may only initiate those proceedings by “[a] motion for sanctions . . . made separately from other motions or requests.”22  Under that plain language, if FuelCell seeks sanctions for conduct it believes violates Rule 11, it must do so in an independent motion, not in argument opposing unconditional leave to amend. And, in my view, it is distracting, detrimental to the famed collegiality of the Delaware bar, and counterproductive to the “just, speedy and inexpensive determination” of judicial proceedings to summon Rule 11 in rhetoric.23

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Chancery Declines to Order Reserve for Fraud Claims Against Dissolving Corporation Under DGCL Section 280

There remains a relative paucity of opinions addressing the nuances of the dissolution statute under DGCL Section 280, compared to the Delaware decisions addressing other sections of the DGCL, so we refer to a September 2020 Court of Chancery decision that denies a Motion for Reargument under Rule 59(f) of a ruling that rejected a request to set aside a reserve for a fraud claim–even though the letter ruling was barely three-pages long–in the matter styled In re Swisher Hygiene, Inc., 2018-0080-SG (Del. Ch. Sept. 4, 2020). The prior decision was highlighted here.

The Court explained that the allegations did not state a “creditor claim”, though the ruling expressly did not prejudice the right to “bring litigation to determine” the fraud claim, which related to disputed ownership of stock in the company being dissolved.

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Chancery Enforces Forum Selection Clause in Charter for Inspection Demand

One of our selected Court of Chancery decisions is almost as noteworthy for what it did not decide as for what was decided. In JUUL Labs, Inc. v. Grove, C.A. No. 2020-0005-JTL (Del. Ch. Aug. 13, 2020), Delaware’s Court of equity enforced an exclusive forum selection clause in a company charter, based at least in part on the internal affairs doctrine, to prevent a stockholder in a Delaware corporation from filing suit in California in reliance on a California statute to demand the inspection of corporate records, notwithstanding a California statute that appears to allow a stockholder to sue in California for corporate records if the Delaware company has its principal place of business in California.

What the Court did not decide is whether a stockholder may contractually waive her rights under DGCL section 220. Count this writer as a skeptic on that point. The Court reviewed several overlapping agreements, such as a stock option exercise agreement, that the stockholder signed and that purported, at least in the company’s view, to waive inspection rights under DGCL section 220. Some of the agreements were governed by Delaware law and some by California law.

This decision could be the topic of a law review article due to the many core principles of corporate law and doctrinal underpinnings the Court carefully analyzes. But, we only provide a few bullet points with an exhortation that the whole opinion be reviewed closely.

  • The Court provides an in-depth discussion of the foundational concepts that undergird the internal affairs doctrine as it applies to the request for corporate records, as well as related constitutional issues that arise.
  • But footnote 7 acknowledges contrary authority that suggests that a local jurisdiction may apply its law to a demand by a local resident for corporate records of a foreign corporation.
  • The Court compares DGCL section 220 with its counterpart in the California statutory regime.
  • The exclusive forum selection clause in the charter was addressed, and the Court explained that but for this provision, the California court would be able to apply DGCL section 220.
  • Importantly, the Court emphasized that is was not deciding whether a waiver of DGCL section 220 rights would be enforceable. Although at footnote 14 the Court provides citations to many Delaware cases that sowed doubt about the viability of that position–but then the Court also cited cases at footnote 15 that more generally recognized the ability to waive even constitutional rights.
  • Footnote 16 cites to many scholarly articles, and muses about the public policy aspects of the unilateral adoption of provisions in constitutive documents, such as forum selection clauses in Bylaws. Early in the opinion, at footnote 7, by comparison the Court waxes philosophical about the concept of the corporation as a nexus of contracts–as compared to it being viewed as a creature of the state. The latter view has implications about the exercise of one state’s power in relation to other states, especially when private ordering may be seen as private parties exercising state power by proxy.

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Chancery Clarifies Nuances of Section 220 Stockholder Demand for Inspection Rights

A July 2020 Delaware Court of Chancery opinion provides insights into nuances of DGCL Section 220 as it relates to the rights of stockholders to inspect corporate books and records, and deserves to be in included in the pantheon of Delaware decisions on this topic. It must be read by anyone seeking a complete understanding of Delaware law on Section 220. In Woods v. Sahara Enterprises, Inc., C.A. No. 2020-0153-JTL (Del. Ch. July 22, 2020), the Court provided warmly welcomed clarity about important nuances of DGCL Section 220 with eminently quotable passages for practitioners who need to brief these issues. See generally overview of takeaways from 15 years of highlighting Section 220 cases, and compare a recent Delaware Supreme Court decision about contract-based rights to inspect corporate books and records.

This short overview will only provide several of those worthy passages in the format of bullet points.

Among the more noteworthy aspects of this notable decision are the following.

  • A consequential aspect of this jewel of a decision is the instruction by the Court that there is no basis in Delaware law to require a stockholder demanding corporate records under Section 220 to explain why the stockholder wants to value her interest in the company–in order to satisfy the recognized proper purpose of valuation. See Slip op. at 11; and 14-15.
  • The Court provided an extremely helpful list of many recognized “proper purposes” needed to be shown to satisfy Section 220. See Slip op. at 8-9.
  • The Court also recited several examples of what showing is recognized as sufficient to satisfy the “credible basis requirement” to investigate mismanagement pursuant to Section 220. See Slip op. 18-19.
  • An always useful recitation of the basic elements of the fiduciary duty of directors of a Delaware corporation and the subsidiary components of the duty of loyalty and care, are also featured. See Slip op. at 20.
  • The Court categorized the specific requests for documents in this case as follows: (i) formal board materials; (ii) informal board materials; and (iii) officer-level materials. Then the Court expounds on the different focus applicable to each category.
  • Notably, after quoting the actual document requests, the Court found that some of them were overly broad–but the Court edited and narrowed some of the requests before concluding that the company was required to produce the Court-narrowed scope of documents.

Bonus supplement: Prof. Bainbridge, a nationally prominent corporate law scholar, provides learned commentary on this case and Section 220 jurisprudence generally. Readers should recognize the good professor as the prolific author who scholarship has been cited in Delaware Court opinions.

Link to original post. 

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*Francis G.X. Pileggi is the managing partner of the Delaware office of Lewis Brisbois Bisgaard & Smith LLP, and the primary author of the Delaware Corporate and Commercial Litigation Blog at www.delawarelitigation.com.

**Chauna A. Abner is a corporate and commercial litigation associate in the Delaware office of Lewis Brisbois Bisgaard & Smith LLP.

A recent Delaware Supreme Court decision should be required reading for anyone interested in the latest iteration of Delaware law on the contract-based right to demand “books and records” in the alternative entity context. Delaware’s High Court ruled in Murfey v. WHC Ventures, LLC, Del. Supr., No 294, 2019 (July 13, 2020), that the Court of Chancery erred by interjecting into a limited partnership agreement a statutory requirement from Section 17-805 that did not appear in the parties’ agreement.

The great importance of this ruling can best be appreciated by emphasizing that the court did not opine in any manner on the statutory requirements for demanding books and records of a business entity–about which so much has been written on these pages over the last 15 years and about which I recently provided an overview of key decisions with the title for the blog post of: Demands for Corporate Documents Not for the Fainthearted.

I will add to that characterization of Delaware decisions interpreting statutory provisions for demanding corporate documents, a general observation based on the instant decision: Contract-based demands for books and records of business entities are not for the fainthearted either. A few reasons that support my observation include the following:

  • This Supreme Court decision features the en banc Justices split 3-2, along with a less-than-common reversal of a Chancery decision. So, that procedural note underscores that 6 of the best legal minds in Delaware (5 jurists on the high court and 1 in Chancery rendering opinions in this case) cannot find unanimity on this issue.
  • The original demand in this case was made on January 10, 2018. The Chancery complaint was filed in September 2018.  Through no fault of the court system, this final decision on appeal came down on July 13, 2020. About 2 years is still lightening-fast for the period from filing a complaint to a final decision by a state’s highest court, but that still implies substantial legal fees and the need for financial and other types of stamina for someone who is serious about seeking corporate records.
  • Although this decision provides authoritative guidance on this nuance of Delaware business litigation, a careful parsing of the opinion still reveals a fertile field for indeterminacy–which makes it a challenge for the lawyers toiling in this vineyard who are trying to predict the outcome of this type of contract interpretation dispute–even if one need not be concerned with applying the multitude of court decisions applying the statutory provisions for inspection rights in this context.
  • I’ll end my introductory observations on a positive note: despite the plethora of case law interpreting the various statutory provisions for demanding books and records, such as Section 220 and Section 18-305, this decision is a welcome addition to the relatively few published Delaware opinions that address the purely contract-based right to books and records of an alternative entity.

Basic Factual Background

Based on the assumption that readers of this post are familiar with the basics of Delaware law in this area, I’m only highlighting the irreducible minimum amount of facts to provide context for the key legal principles announced.

This case followed a typical pattern. The company provided some documents initially, and at the time of trial the only issue was the very limited documents the company refused to produce. Somewhat unusual was that only one specific type of document was the subject of the trial court decision and the appeal: the K-1 of the other limited partners in the limited partnership. Although the company allowed counsel for the plaintiff and the plaintiff’s valuation expert to review those K-1s, they refused to let the plaintiffs themselves review the K-1s of other limited partners–even subject to the common confidentiality agreement.

The limited partnership agreements involved allowed for a rather broad scope of documents to be demanded, including tax returns which were specifically listed as being subject to production. The company took the curious position that a K-1  (of other limited partners) was not part of the tax returns of the company–or at least not within the scope of documents they need to produce.

Primary Issue Addressed on Appeal

Whether the Court of Chancery erred by injecting into the terms of the agreement that provided for a right to books and records–additional statutory prerequisites. Short answer: yes.

High Court’s Reasoning–Key Takeaways

The majority opinion made quick work of dispensing with the defense that valuation was not a valid basis for requesting the disputed documents or that tax returns were not needed to complete a valuation. See, e.g., footnotes 65 and 66 as well as related text. More notably, the court found that the statutory notion of a “proper purpose” was not applicable to contract-based demands. See, e.g., footnote 53 and accompanying text (quoting with approval prior decisions so holding.)

Also noteworthy is the Court’s reference to dictionary definitions of words, including prepositions, at issue in this case. See footnotes 32 and 33.

The Court reviewed many prior Delaware decisions that addressed when, if ever, it would be appropriate to infer words or conditions that do not appear in the terms of an agreement, such as statutory prerequisites. Slip op. at 18-25.

A key part of the Court’s reasoning was that: because the partnership agreements involved

… do not expressly condition the limited partner’s inspection rights on satisfying a “necessary and essential” condition [a statutory concept], and given the obvious importance of tax return and partnership capital contribution information to the Partnerships’ investors, as evidenced by the agreements, we are not persuaded that such a condition should be implied.

Slip op. at 25

The majority opinion’s “rebuttal” of the dissenting opinion deserves to be read in its entirety. Slip op. 32 to 37. Two especially notable excerpts:

  • ” The words ‘necessary and essential’ do not appear in the written agreements”. Slip op. at 35.
  • “… we also do not agree that the parties to a limited partnership agreement have to expressly disclaim any conditions applied in the Section 220 context (or the Section 17-305 context….)” Footnote 85.

 

A recent Delaware Court of Chancery post-trial opinion addressing a demand for books-and-records by an LLC member did not attract my attention for the rather routine legal issues it decided, but it provides an opportunity to rely on it as a launchpad for broader commentary generally on this common type of Delaware corporate and commercial litigation. This post is intended for advanced readers of these pages who have followed at least some of the 200-plus highlights on this blog regarding Delaware decisions on DGCL Section 220 over the last 15 years, and a fewer number of case highlights regarding the analog to Section 220 in the Delaware LLC Act: Section 18-305.

In Riker v. Teucrum Trading, LLC, C.A. No. 2019-0314-AGB (Del.Ch. May 12, 2020), the Court determined after trial that only some of the requested data requested by the LLC member, and not yet provided, was required to be produced, although the case followed a familiar pre-trial pattern: The company initially refused to produce most of the documents requested prior to the suit being filed; then additional documents were produced after suit was filed, but not as many as requested. At trial, the Court needed to determine how many of the documents still requested were required to be produced.

Procedural History

The complaint was filed in April 2019. Court guidelines suggest a trial date within 90 days of the complaint for summary proceedings such as these, but through no fault of the court, that timetable may not always be possible. In this case, a pre-trial mediation took place that resulted in additional documents being produced, and that process added additional months to the timetable for trial. Post-trial briefing was also submitted.

Highlights of Decision

  • The Court held that all the “form and manner” requirements of the statute were met, in terms of stating a proper purpose, for example. See pages 8-18.
  • Valuation was recognized as a well-established statutory proper purpose, so the focus was on whether the documents requested were necessary in order to perform a valuation using the DCF method, which the plaintiff testified he was qualified to perform. The Court held that he was entitled to only one of the documents requested–most of them already having been produced. See generally, Lim v. PowerWise, highlighted on these pages, a 2010 Chancery decision that determined what documents were necessary to pursue the proper purpose of valuation in the context of that case.
  • The second purpose was recognized as proper–investigation of mismanagement–but a prerequisite for pursuing such a purpose is presenting a “credible basis” of wrongdoing which the plaintiff in this case did not establish in connection with the documents requested for this category of requests. See pages 21-28.

General Commentary on Section 220/Books-and-Records Cases

Hundreds of highlights on these pages, over the last 15 years, of Delaware decisions on demands for books and records–based on both the corporate statute and the LLC Act–and the many cases of this type that I have handled over the last 30 years or so, reveal a few common themes:

  • Although a reading of DGCL Section 220 and Section 18-305 of the LLC Act may appear to the casual observer as relatively simple and straightforward, the many hundreds of published decisions interpreting those statutes tell a different story.
  • Exhortations in ample Delaware corporate litigation decisions instruct Delaware lawyers to “employ the tools at hand”, including Section 220,  prior to filing a plenary action, especially a derivative suit which requires that one plead with particularity why pre-suit demand is futile. But what a blunt instrument Section 220 can be. Notably, Section 220 case law is often used by analogy when applying Section 18-305.
  • Highlights on these pages of decisions on this topic recite the many nuances and prerequisites that must be mastered for a successful books and records claim under either statute, often added by judicial gloss, which are not obvious from a reading of the statutes only.
  • Having represented both companies and stockholders/members in these cases over the years, there are many traps for the unwary. Companies have many arrows in their quiver to oppose a request under either statute. In addition to challenging a proper purpose (which can include a defense that the stated purpose is not the “true” purpose), a fertile field for disputes in this area relates to whether each of the documents requested is necessary to accomplish the stated purpose.
  • These cases are not for the faint of heart because:

(i) As this case indicates, the litigation can last for a year or more (and some cases highlighted on these pages have lasted several years through appeal);

(ii) In connection with the litigation lasting as long as some plenary cases, the fees incurred in these cases can be substantial for matters such as discovery (however limited and circumscribed by the narrow scope and summary nature of these cases) and motion practice, for example, related to discovery disputes (though dispositive motions are strongly discouraged.);

(iii) As the instant case highlighted above exemplifies, the results of trial in these types of case are often unsatisfying to the extent that even if one is successful–which is never a certainty–the court merely orders the production of documents. This contrasts with a typical trial in which success often means a monetary award or substantive relief. So too, an order for production of records does not equate with receipt of records. It’s not uncommon that a continuing struggle ensues to enforce the production ordered by the court.

(iv) Truly egregious behavior, as an exception to the American Rule, must be presented before the court will engage in fee shifting–otherwise each party pays its own fees. Thus, the economics must support pursuing one of these cases through trial, and possible appeal.

UPDATE: Professor Stephen Bainbridge, a nationally-prominent corporate law professor whose scholarship is often cited in Delaware court opinions, kindly linked to this post on his blog.

This post was prepared by Frank Reynolds, who has been following Delaware corporate law, and writing about it for various legal publications, for over 30 years.

Rallye Motors Holding, LLC cannot use Delaware’s McWanedoctrine to force its ex-CEO to move his books-and-records action to New York, where a fellow member and ex-employee of that limited liability company is litigating related claims including records inspection demands, the Chancery Court has ruled in Stanco v. Rallye Motors Holding, LLC, No. 2019-0751-SG (Del. Ch. Dec. 23, 2019).

Vice Chancellor Sam Glasscock’s Dec. 23 memorandum opinion declined to dismiss Joseph Stanco’s records inspection suit filed under Delaware LLC Act Section 18-305 – the LLC analog of Section 220 of the Delaware General Corporation Law – after rejecting two novel Rallye arguments of interest to alternate entity counsel.

  • First, the Court found that the LLC agreement did not clearly require Stanco to waive his right to file his records action in Delaware, where Rallye is chartered, because he was a managingmember as well as an officer.
  • Second, the vice chancellor said Rallye cannot use the seminal forum non conveniens decision in McWane v. McDowell-Wellman to force Stanco to combine his records action with a related suit by a third party because McWane: “should not be employed to defeat a plaintiff’s choice of forum.” McWane Cast Iron Pipe Corp. v. McDowell-Wellman Eng’g Co., 263 A.2d 2821 (Del. 1970).

Stanco says he had worked for Rallye, a holding company for five Long Island automobile dealerships, since 1980 and had acquired a 5.5 percent member ownership, a seat on Rallye’s board of members and an appointment as managing member when he was fired without cause in 2017.

Two years later, he demanded inspection of Rallye’s books and records to value his ownership interest, evaluate Rallye’s financial condition, the performance of its management, the reason for its failure to continue making distributions to shareholders and the propriety of company disclosures.

No ‘clear expression’

Two weeks after he filed his inspection complaint on Sept. 19, Rallye moved to dismiss it from Chancery Court, but the vice chancellor found that, “Generally, except as limited by contractual waiver, the members of a Delaware LLC have the right to vindicate proper books and records demands in this court” and waivers of those rights must include “the clear expression of the intent to relinquish the right.”

Vice Chancellor Glasscock ruled that Stanco “could not have intended to waive his rights to a books and records as a manager,” because in his capacity as a managing member he would have had access to the company’s books and records.

The McWane argument fails because Rallye cannot demonstrate “a high degree of hardship” should the litigation go forward in Delaware, and does not even attempt to make such a showing, he said.

Under McWane, “this court’s discretion is to be freely exercised in favor of a stay or dismissal where there is a prior action pending elsewhere, in a court capable of doing prompt and complete justice, involving the same parties and issues,” but that’s not the case here, the Court noted.

In whose interest?

The action that Rallye wants Stanco to join in the interest of efficiency is a books and records suit filed by Nicholas Toomey, a member and ex-employee of the LLC.  Toomey v. Rallye Motors Holding LLC et al., Index No. 613005/2019 (N.Y. Sup. Ct.).

According to Rallye, Toomey was Stanco’s “cohort” who was fired along with him for cause in 2017 and the two are co-plaintiffs in a related New York state court breach of contract action.  Stanco and Toomey v. Rallye Motors Holding LLC, Index No. 612155/2017 (N.Y. Sup. Ct.).

Rallye argues that the two New York suits have “a common nucleus of operative fact” and “share the same issues” for purposes of a McWane analysis, but the vice chancellor found the connection to be “insufficient to support my exercise of discretion under McWane.”

Although it might be efficient for Rallye to address both records inspection actions together, McWane“seeks to promote efficient litigation by vindicating a plaintiff’s choice of forum” and there is no overlap in the parties aside from the common defendant nor are the issues the same, he said.

McWane is not – and should not be – that flexible,” Vice Chancellor Glasscock said in denying Rallye’s motion to dismiss.

The Court of Chancery just decided a case that elucidates the rights of members and managers of an LLC to books and records of the LLC. A few bullet points will extract the nuggets of this decision. You should read the whole thing if you need to know the latest Delaware law on this topic. RED Capital Investment LP v. RED Parent LLC, C.A. No. 11575- VCN (Del. Ch. Feb. 11, 2016).

  • First, this ruling should be compared to the recent ruling in the Yahoo opinion highlighted on these pages. Although this decision did not address electronically stored information (ESI), readers are likely aware that decisions regarding demands for the books and records of an LLC often apply the rationales in rulings interpreting the analogous DGCL provisions (however different they may be)–therefore, you read it here first that the reasoning in the Yahoo decision that ESI must be produced in a Section 220 demand under the DGCL, will also be applied in the future to demands for books and records under Section 18-305 of the Delaware LLC Act, to require ESI to be produced when there otherwise is an entitlement to books and records under the LLC Act.
  • The money quote, which underscores the additional rights of managers of LLCs (and directors of corporations) to books and records:

    Managers are entitled to all information falling within Section 18-305(a)(1)-(6) that is “reasonably related to the position of manager.”40  This language is tantamount to that used in 8 Del. C. § 220 with respect to director requests for corporate information.41  As such, LLC managers should be afforded similar “unfettered”42  access to company books and records, absent restrictions in an applicable LLC agreement. With this context, the Court is unwilling to deprive an LLC holding company’s manager of books and records of the company’s wholly-owned operating entities…. (footnotes omitted)

  • One big difference between DGCL Section 220 and Section 18-305 of the LLC Act, is that LLC operating agreements can limit the rights that a member or manager may otherwise have to demand books and records. The LLC Act expressly says so. Section 220 does not expressly say so, but in a teleconference for a relatively recent Section 220 case, one member of the Court of Chancery informed the parties that a contract that purported to limit rights under Section 220 was not likely to be enforced. The name of the case was Brazil Mining. That case comes to mind readily, but I expect that there are similar cases, some of which have been featured on these pages over the last 10 years.
  • This opinion is also helpful in how it addresses issues involving the interface between the rights of members or stockholders in affiliated entities relating to access to records of subsidiaries and parent entities in the corporate context and LLC context.

UPDATE: In a Law 360 article, Jeff Montgomery reports that subsequent to this decision, the company indicated in a letter that it would not produce the documents until the appeal period ended, which apparently was on or about March 15, as it had not yet decided whether to appeal. Vice Chancellor Noble, who previously set the end of February for his retirement from the bench, responded to that position, described by the opposing side as a self-granted unilateral stay, by ordering that the data be produced by March 3.

Jagodzinski v. Silicon Valley Innovation Company LLC, C.A. No. 6203-VCP (Del. Ch. Feb. 14, 2012).

Issue Addressed

The issue addressed in this case was whether the Court of Chancery should grant a Motion for Contempt and for the Appointment of a Receiver in connection with a failure to comply with a prior order entered by the Court granting access to books and records pursuant to Section 18-305 of the Delaware Limited Liability Company Act (Title 6 of the Delaware Code), and the limited liability company agreement of the defendant company.

Background

The Court entered an order in August 2011 that the defendant company must produce books and records.  Again, in October 2011, the Court granted in part and denied in part a prior motion to contempt for failure of the company to comply with the August order.  In November 2011, the plaintiff filed the most recent pending motion for contempt and for a receiver.  After the most recent motion was filed, also in late November 2011, the Court ordered the company to file an opposition to the most recent motion for contempt, and for the third time also directed the company to make the production required in the August order.

The company did not file any reply brief or memorandum in opposition to the most recent  motion for contempt.  The record also indicates that the defendant has not produced all of the documents required in the August, October or November orders.

The defendant purported to move for an extension of time to respond to the second motion for contempt although the motion to extend was not properly filed with the Court and therefore the Court did not consider it.  The Court explained that even if it did consider the motion to extend time, the motion would not be granted.  The Court reasoned that under Court of Chancery Rule 6(b) that the Court may extend time only when “the failure to act was the result of excusable neglect.”  That is, “neglect which might have been the act of a reasonably prudent person under the circumstances.”  The company could not meet this standard.

Analysis

The Court explained that under Court of Chancery Rule 70(b), the Court “may find a party in contempt when it fails to obey or to perform any order of which it has knowledge.”  It is clear that the company violated essential terms of the prior orders in several ways, such as failing to deliver or make available all the documents the Court ordered it to produce in the August, October and November orders.  The company still has not fully complied with those orders, nor has it complied with an order of several months ago requiring it to obtain new Delaware counsel.  Thus, the Court found the company in contempt.

Appropriate Remedy for Contempt

The Court explained that it has broad discretion in formulating a remedy for contempt of its orders.  See cases cited at footnote 4 for authority, based on the history of this case and the multiple failures to comply by the defendant.  The Court also awarded attorneys’ fees and costs.  In addition to contempt penalties, or as an additional penalty, the plaintiff also sought the appointment of a receiver.

Criteria for Appointment of Receiver

The Court explained that except where the certificate of formation has been cancelled, Delaware law is silent on the appointment of a receiver for an LLC.  See footnotes 6 and 7.  The LLC Agreement in this case did not address the issue and the relevant statutory provision of the LLC Act, at Section 18-1104, provides that “in any case not provided for in this chapter, the rules of law and equity shall govern.”

The Court also observed that it has the inherent equitable power to appoint a receiver.  See footnote 9.  The Court also acknowledged that the appointment of a receiver is a “extraordinary remedy” (citing Roth v. Laurus U.S. Fund, L.P., 2011 WL 808953, at *5 (Del. Ch. Feb. 25, 2011)).  One of the factors in determining whether a receiver should be appointed is when it is necessitated by the exigencies of a case, and whether “some real beneficial purpose will be served thereby.”  See footnotes 11 through 13.

The Court reasoned that based on the evidence which demonstrated that the company only had one employee, who cannot be relied on to produce the documents required under the order, that it was appropriate to appoint a receiver.  The Court added that a receiver was appropriate because the company appeared to have limited or no resources, and may not be able to pay a receiver out of current funds.  With that in mind, the Court accepted the recommendation of the plaintiff that the Court appoint an agent of the plaintiff, who appears to have the necessary skills, and that would also minimize the financial strain on the company.

The Court limited the power and the appointment of the receiver “only to the extent necessary to cure the contempt by effecting the production ordered under 6 Del. C. Section 18-305.”  Thus, the powers of the receiver were limited to retrieving and producing the documents ordered by the Court in the underlying books and records litigation and actions reasonably related to that purpose.  The receiver may attempt to obtain documents at issue from third parties where the company can claim to have control over those documents, but once the receiver completed his efforts to collect and produce the books and records, he will be discharged.

[In an unrelated and separate opinion, also issued this month, involving the dissolution of a company, the Court of Chancery appointed a receiver in the Calypso case highlighted here.]

In closing, however, the Court underscored that its restriction on the scope of the receiver is without prejudice to the ability of the plaintiff to petition the Court to expand those powers in a later proceeding on the merits.

Noteworthy 2011 Corporate and Commercial Decisions from Delaware’s Supreme Court and Court of Chancery.

By:  Francis G.X. Pileggi and Kevin F. Brady.

Introduction

This is the seventh year that we are providing an annual review of key Delaware corporate and commercial decisions. During 2011, we reviewed and summarized approximately 200 decisions from Delaware’s Supreme Court and Court of Chancery on corporate and commercial issues.  Among the decisions with the most far-reaching application and importance during 2011 include those that we are highlighting in this short overview.  We are providing links to the more complete blog summaries, and the actual court rulings, for each of the cases that we highlight below. Prior annual summaries are linked in the right margin of this blog.

Top Five Cases from 2011

We begin with the Top Five Cases on corporate and commercial law from Delaware for 2011 and we are glad to see that at least four of them have some support from the bench as these were the cases that four Vice Chancellors highlighted as important decisions in a recent panel presentation that they offered in New York City in early November 2011.  Those cases were the following:  In Re: OPENLANE Shareholders Litigation; In Re: Smurfit Stone Container Corp. Shareholder Litigation; In Re: Southern Peru Copper Corp. Shareholder Litigation and Air Products and Chemicals, Inc. v. Airgas Inc., and Kahn v. Kolberg Kravis Roberts & Co., L.P.

In Re: OPENLANE Shareholders Litigation. In what many commentators referred to as a “sign and consent” transaction, in which the majority shareholders and the board of directors had sufficient control to provide the statutorily required consent, the Court of Chancery determined that the Revlon standard was satisfied and fiduciary duties were not breached notwithstanding the Omnicare case and even without customary safeguards such as a fairness opinion. See fuller summary here.

 In Re: Smurfit Stone Container Corp. Shareholder Litigation. The Court of Chancery denied a motion for preliminary injunction and determined that the Revlon standard applied to a merger for which the consideration was split roughly evenly between cash and stock. See fuller summary here.

In Re: Southern Peru Copper Corp. Shareholder Litigation. In what may be the largest award granted in the Court of Chancery’s venerable history, a judgment was entered for $1.2 billion (later amended to $1.3 billion) for breach of fiduciary duties in connection with an interested transaction. With interest, the total is expected to be $2 billion.  The Court later awarded attorneys’ fees of 15% which amounts to $300 million, in this derivative action. See fuller summary here.

Air Products and Chemicals, Inc. v. Airgas Inc. This magnum opus of over 150-pages in length will be the focus of scholarly analysis for many years to come. For purposes of this short blurb, it ended a year-long takeover battle between two determined companies, with the Court of Chancery ruling, among other things, that the target company was not required to pull its poison pill when the board determined that the offer for the company was too low. See fuller summary here.

Kahn v. Kolberg Kravis Roberts & Co., L.P.  This Delaware Supreme Court decision reversed and remanded an opinion by the Court of Chancery interpreting “a Brophy claim as explained in Pfeiffer.”  The issue before the Court was whether a stockholder had to show that the company had suffered actual harm before  bringing  a breach of loyalty claim that a fiduciary improperly used the company’s material, non-public information (a Brophy claim).  The Supreme Court rejected that part of the Chancery’s decision in Pfeiffer v. Toll which requires a showing of actual harm to the company.  See fuller summary here.

We also selected the following additional noteworthy cases:

Shareholder Litigation

In Re: John Q. Hammons Hotels, Inc. Shareholder Litigation.  Despite the application of the entire fairness standard, the Court concluded that the merger price was entirely fair, the process leading to the transaction was fair, that there was no breach of fiduciary duty, and therefore no claims for aiding and abetting fiduciary duty.  See fuller summary here.

Reis v. Hazelett Strip-Casting Corp.  The Court applied an entire fairness analysis and held that the attempt to cash out minority shareholders via a reverse split was neither the result of a fair process nor did it involve a fair price.  See fuller summary here.

In re: Del Monte Foods Co. Shareholders Litigation. This first of three rulings enjoined a shareholder vote on a premium LBO transaction and the buyers’ deal protection devices.  The Court also held that the advice that the target board received from a financial advisor (who also did work on the deal for the bidder) was so conflicted as to give rise to a likelihood of a breach of fiduciary duty and the Court indicated that the financial advisory firm could face monetary damages due to aiding and abetting the potential breach.  See fuller summary here.

In re: Massey Energy Company Derivative and Class Action Litigation.  The Court declined to enjoin a proposed merger.  The Court noted that the derivative claims that the plaintiffs argued were not being fairly valued as part of the merger, would become assets of the surviving corporation.  The Court reasoned in part that the shareholders should decide for themselves whether to exchange their status as Massey stockholders for a chance to receive value from a third party in an arms-length merger.  See fuller summary here.

Frank v. Elgamal.  This decision exemplifies the different approach taken by different members of the Court in connection with an application for interim fees in a class action.  (Compare the different approach in the Del Monte case.)  See fuller summary here.

Krieger v. Wesco Financial Corp.  This decision determined that holders of common stock were not entitled to appraisal rights under Section 262 when they had the option of electing to receive consideration in the form of publicly traded shares of the acquiring company.  See fuller summary here.

In re: The Goldman Sachs Group, Inc. Shareholder Litigation.  In this first corporate opinion by Vice Chancellor Glasscock, the Court dismissed a derivative action brought against Goldman’s current and former directors based on a failure to make a pre-suit demand.  At issue was Goldman’s allegedly excessive compensation structure.  See fuller summary here.

Contested Director Elections

Genger v. TR Investors, LLC.  In this opinion, the Delaware Supreme Court addresses electronic discovery issues and contested elections for directors involving DGCL Section 225. See fuller summary here.

Johnston v. Pedersen.  This opinion determined that directors breached their fiduciary duties when issuing additional stock and as a result were not entitled to vote in connection with the removal of the incumbent board and the election of the new directors.  See fuller summary here.

Section 220 Cases

King v. VeriFone Holdings, Inc. This Delaware Supreme Court ruling reversed a Chancery decision that found a lack of proper purpose in a suit by a shareholder seeking books and records pursuant to Section 220.  Delaware’s High Court explained that it remains preferable to file Section 220 suits for books and records prior to filing a derivative suit, but holding that such a chronology is not, per se, a fatal flaw in a Section 220 action.  See fuller summary here.

Espinoza v. Hewlett Packard Co. This affirmance of Chancery’s denial of a §220 claim was based on the requested report to the board being protected by the attorney/client privilege.  (This is one of several decisions in this matter.) See fuller summary here.

Graulich v. Dell., Inc.  This is a Section 220 case in which Chancery denied a request for books and records due to the underlying claims being barred by a previous release and due to the shareholder not owning the shares during the period of time for which he was requesting documents.  See fuller summary here.

Alternative Entity Cases

CML V, LLC v. Bax.  This Delaware Supreme Court decision determined that creditors of an insolvent LLC are not given standing by the Delaware LLC Act to pursue derivative claims unlike the analogous situation in the corporate context.  See fuller summary here.

Sanders v. Ohmite Holding, LLC.  This decision clarified the rights of a member of an LLC that demanded books and records of an LLC.  The Court determined that pursuant to Section 18-305 of the Delaware LLC Act a member may seek records for a period prior to becoming a member of the LLC.  See fuller summary here.

Achaian, Inc. v. Leemon Family LLC.  This opinion addressed the transferability of interests of a member of an LLC and specifically whether one member of a Delaware LLC may assign its entire membership interests, including voting rights, to another existing member, notwithstanding the provision in an agreement that requires the consent of all members upon the admission of a new member.  See fuller summary here.

Jurisdictional or Procedural Issues

Central Mortgage Co. v. Morgan Stanley Mortgage Capital Holdings LLC.  In this decision, a Delaware Supreme Court determined that Delaware would not follow the standards for a motion to dismiss under Rule 12(b)(6) announced by the U.S. Supreme Court in the Twombly or Iqbal opinions.  See fuller summary here.

Hamilton Partners, LP v. Englard.  This decision addressed the issue of personal jurisdiction over directors and interlocking entities, as well as demand futility in the context of a double derivative shareholders suit.  (Although this was decided at the end of 2010, it was important enough to include in this list as it was issued after our deadline for our compilation last year). See fuller summary here.

Encite LLC v. Soni.  This decision rejected a request for an extension of a deadline for submitting expert reports because the Court did not approve an amendment to the Scheduling Order.  See fuller summary here.

Whittington v. Dragon Group.  In this latest iteration of multiple decisions in this long-running saga, the Court examines the doctrine of claim preclusion, issue preclusion and judicial estoppel.  See fuller summary here.

In re: K-Sea Transportation Partners, L.P. Unitholders Litigation.  This decision provides a useful recitation of the standard used in Chancery for deciding whether to grant a motion to expedite proceedings, and it also reviews language in a limited partnership agreement which arguably was an effective waiver of traditional fiduciary duties as allowed by the LP statute.  See fuller summary here.

Sagarra Inversiones, S.L. v. Cemento Portland Valderrivas, S.A.  This ruling determined that the standard of “irreparable harm” granting injunctive relief was not satisfied based on the financial condition of the defendant which was “not poor enough” to convince the Court that a money judgment would not make the plaintiff whole.  (This is one of several decisions in this matter.) See fuller summary here.

ASDC Holdings LLC v. The Richard J. Malauf 2008 All Smiles Grantor Retained Annuity Trust.  This decision discussed the enforceability of forum selection clauses and in particular when those clauses will be enforced despite a related case being filed first in another forum.  See fuller summary here.

Gerber v. ECE Holdings LLC.  This decision discusses the difference between a motion to supplement and a motion to amend a complaint.  See fuller summary here.

Advancement

Fuhlendorf v. Isilon Systems, Inc.  This decision addresses the advancement of fees incurred by officers and directors sued in connection with their corporate roles.  The specific issue in this case was whether the corporation should pay for all of the costs of a Special Master appointed to review the interim application for fees.  The case also discusses the common procedure employed to review disputed monthly legal bills in advancement cases.  See fuller summary here.

Receiver or Dissolution

Pope Investments LLC v. Benda Pharmaceutical Inc.  This decision rejected the application for the appointment of a receiver on the grounds that while the plaintiff demonstrated that the defendant was insolvent, the plaintiff failed to show that “special circumstances existed which would warrant the appointment of a receiver.”  See fuller summary here.

Stephen Mizel Roth IRA v. Laurus U.S. Fund, L.P.  This decision rejected a request to dissolve a limited partnership and refused to appoint a receiver in the context of an investment fund that was in liquidation mode but was not dissolved, nor was it winding-up as that term is used in the statute.  See fuller summary here.

Legal Ethics

BAE Systems Information and Electronics Systems Integration, Inc. v. Lockheed Martin Corp.  This opinion addresses Delaware Lawyers’ Rule of Professional Conduct 3.4(b) and discusses those situations in which a fact witness may be compensated for the “lost time” away from his “day job” suffered while testifying.  See fuller summary here.

Judy v. Preferred Communications Systems, Inc.  This decision addresses the issue of legal ethics involved in determining whether an attorney may assert a retaining lien over the documents of a former or delinquent client.   See fuller summary here.

Common Law v. Statutory Claims

Overdrive, Inc. v. Baker & Taylor, Inc.  In this last formal decision  by Chancellor Chandler, the Court discussed how the Delaware Uniform Trade Secrets Act displaces conflicting tort and other common law claims that are grounded in the same facts which would support the statutory misappropriation of trade secret claims.  See fuller summary here.

Damages for Breach of Agreement to Negotiate in Good Faith

PharmAthene, Inc. v. SIGA Technologies, Inc. This Court of Chancery decision awarded damages for breach of a contractual obligation to negotiate in good faith and fashioned an equitable remedy that required the sharing of profits from the production of a product that the defendant failed to negotiate the license of in good faith. There are several decisions involving contract law by the Court of Chancery in this matter, the most recent ruling denying a motion for reargument. See fuller summary of the most recent decision here.

Postscript

On a final note, the last week of 2011 saw the sudden and sad passing of one of the nation’s foremost experts on alternative entities, Professor Larry Ribstein, who was often cited in opinions of the Delaware Courts. He coined the word “uncorporations” to refer to alternative entities and was the author of many treatises, law review articles and other publications on uncorporations, jurisdictional competition, the business of law firms and related topics involving the intersections of law and business. He was an iconic figure in the law, and the legal profession is better because of his many contributions.

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UPDATE: The Harvard Law School Corporate Governance Blog published this post here. The NACD’s Directorship.com site kindly published this article as a lead story on Jan. 5, 2012, available here. Professor Stephen Bainbridge graciously commented on this summary in his post available here. Professor Joshua Fershee on the Business Law Prof  Blog linked to this summary with kind references here.

DFG Wine Company, LLC v. Eight Estates Wine Holdings, LLC, C.A. No. 6110-VCN (Del. Ch. Aug. 31, 2011).  This decision was initially sealed and not available to the public until recently.

Issue Addressed

This is a books and records action involving an LLC, based on Section 18-305 of the Delaware LLC Act.  In this post-trial 31-page opinion, the Court granted in part the request for  documents.

Background

DFG sent a written demand in late 2010 for 16 categories of documents.  The stated purposes for seeking the records were two-fold:  (1) To determine the value of its investment in Eight Estates; and (2) To determine whether it should appoint a representative to sit on the board of managers.  The 16 categories of requested records were itemized on pages 4 through 6 of the letter opinion.  After an exchange of letters in which Eight Estates maintained that neither the LLC Agreement nor 6 Del. C. Section 18-305 required the production of the requested records, and after making a final request on Dec. 7, 2010 for reconsideration, DFG filed this lawsuit on January 4, 2011.

On January 24, 2011 Eight Estates provided DFG with the documents described at page 7 of the slip opinion. The LLC Agreement defined the rights of members and managers to inspect the books and records of the company and itemized specific records including tax returns and financial statements to which members and managers were entitled.

Specific Issues

The issues for trial were whether Eight Estates completely satisfied the demands of documents requested in categories 1, 4 and 6.  Eight Estates satisfied categories 2, 3 and 5 after the complaint was filed but did not provide any documents responsive to categories 7 to 17.

Why this Decision is Useful

This ruling provides helpful explanations about the scope of documents that are required to be produced for those seeking to value a closely-held company.  The Court explained that because members of a closely-held LLC “do not have access to the same quantity of information available from the regulatory filings of publicly traded companies . . .,” they should “be given slightly broader access rights.”  See footnote 23.

Court’s Reasoning

The Court also explained that the right of limited liability company members to inspect books and records of a limited liability company’s subsidiaries is not made explicit by 6 Del. C. Section 18-305, but nonetheless, Delaware courts have recognized that the statute provides a right to inspect the records of such subsidiaries where “the facts at least suggested the absence, in reality, of separate entities.”  See footnotes 24 and 25 (relying on DGCL Section 220(b)(2) by analogy).

The Court also observed that Section 18-305(c) limits the inspection rights granted to members of an LLC to the extent that the LLC “has the opportunity to establish a good faith belief that disclosure of the desired information would not be in the best interest of the entity . . . .” (citing Arbor Place, L.P. v. Encore Opportunity Fund, LLC, 2002 WL 205681, at *5 (Del. Ch. Jan. 29, 2002)).  Moreover, unlike a Section 220 case, a limited liability company is a creature of contract and the LLC Agreement may grant inspection rights that are “in addition to and separate from” the statutory inspection right.

The Court, unsurprisingly, concluded that the purpose of valuation was a proper purpose.

The Court also determined that it was a proper purpose to seek books and records for the purpose of determining whether to appoint someone, and if so, who to appoint as a member of the board of managers of the LLC.  The Court compared Section 18-305(b), which gives managers the right to examine all the materials described in Section 18-305(e), with the provision of Section 18-305(c) which allows for a good faith defense to a books and records action involving members – – but not managers.

Importantly, the Court emphasized, by reliance on a Delaware Supreme Court decision (in footnote 36), that so long as a single proper purpose related to one’s role as a stockholder is established, all other purposes are irrelevant (relying on DGCL Section 220).

Records of Subsidiary of LLC

The Eight Estates LLC had no value apart from its subsidiary known as Ascentia.  The Court distinguished the Arbor Place case because unlike that case and subsidiaries of the LLC in that opinion, the facts in this case “suggest the absence, in reality, of separate entities.”  The Court reasoned that it would be unfair under these circumstances to require a member of Eight Estates to attempt to value its holdings without providing access to the records of the only asset of the LLC, which are the records of the subsidiary, in order to allow the member to value that asset.  See footnote 43 citing to a decision involving piercing the corporate veil, which relies on a combination of factors and an overall element of unfairness as opposed to a single factor.

Trade Secrets

Although the Court allowed the company to redact any information that would be in the nature of trade secrets, the Court was not persuaded by the defense that the member seeking the information would be using that information in order to “cherry pick” or otherwise damage the competitive position of the company.

See footnote 50, referring to Section 18-305(c) which provides that an objective standard is applied to the belief of a manager that certain information is in the nature of a trade secret–but a subjective standard is applied to a belief of a manager that certain disclosures would not be in the best interest of the company.

Prior Production

The Court also rejected the defense that because a large number of hard copy documents were produced in a separate arbitration proceeding, which were designated as “for attorneys’ eyes only,” that the members seeking books and records would not be able to obtain those same documents in this case.

Scope of Relief and Specific Documents Required to be Produced

The Court determined that state tax returns of the subsidiary were not part of the enumerated documents that members were entitled to under the LLC Agreement, but such returns would be part of the “true and full information regarding the status of the business” to which it was entitled under Section 18-305(a)(1).

The Court also explained that the company did not establish a good faith belief that withholding the information would not be in the best interest of the company, and thus required state tax returns to be produced.  The Court also required the production of the “independent auditor’s report and financial statements” as well as the unaudited financial statements because those documents are reasonably related to the purpose of valuing the membership interests.

The Court also required the production of Employment Agreements with key employees which would be included within the category of “information regarding the affairs of the limited liability company” pursuant to Section 18-305(a)(6), and these documents also contribute to the valuation of the interest in the LLC, and there was no basis to establish the belief of a manager that withholding those records would be in the best interest of the company.

The production of a general ledger of the subsidiary was also required based on Section 18-305(a)(1).  The Court mandated the production of business plans and budgets including projections for future performance, and all documents related to such estimates or projections, subject only to redaction for trade secrets.

The Court also ordered the production of documents related to inventory and non-inventory assets that it determined would be necessary to value an interest in the LLC or its subsidiary.  Likewise, the Court ordered the production of documents related to the relationship of the company with its creditors such as any loan agreements, notes, mortgages and other debts or liabilities.  In addition, the Court required the production of information regarding grape contracts which apparently have great value in connection with valuing a winery.  The Court permitted the production of either the grape contracts themselves or a summary of the contracts that shows how many contracts it has and has had since 2008 and related information about the contracts.

In Sanders v. Ohmite Holding, LLC, C. A. No. 5145-VCL (Del. Ch. Feb. 21, 2011), read opinion here, the Delaware Court of Chancery clarified the rights of a member of an LLC to demand certain books and records of an LLC.

Issue Addressed

 Whether the member was entitled to books and records, pursuant to Section 18-305 of the Delaware LLC Act ( 6 Del. C. Section 18-305), for a period prior to him becoming a member of the LLC? Answer: Yes.

Short Factual Background

Max Sanders loaned $2 million to a member of an LLC and received a security interest in the member’s units as collateral. That member later transferred his interests back to Sanders. In the interim, the member’s units were diluted and instead of having the 7.75% stake that he thought he had, the LLC told Sanders that he only had what the Court described as a "nigh microscopic"  stake of merely 0.000775%. Sanders made a formal demand for 8 categories of books and records relating to why his units were diluted and the value of his interest as well as the performance of the LLC’s management. The LLC denied the request in total. After this action was filed, the LLC did provide tax returns and financial statements but not all the documents requested. Based on that information, the Court found that Sanders had a reasonable basis to believe that additional units were issued to an affiliated party at a deep discount, and thus, questioned whether the LLC received proper consideration for the additional units that were issued.

Holding

The Court determined that Sanders had a proper purpose for inspecting the books and records and that the documents he requested were necessary for him to fulfill that purpose, regardless of whether they pre-date when he formally acquired member status. Thus, summary judgment was granted for Sanders.

Procedural Posture

Both parties filed cross motions for summary judgment which the Court treated as the equivalent of a stipulation for decision on the merits based on the record submitted with the motions, pursuant to Chancery Rule 56(h).

Brief Overview of Key Legal Principles Discussed

As the Court observed:

Section 18-305(a) of the LLC Act provides a member of an LLC with the right,
“upon reasonable demand for any purpose reasonably related to the member’s interest as
a member” of the LLC, to obtain the following records:

(1) True and full information regarding the status of the
business and financial condition of the limited liability
company;

(2) Promptly after becoming available, a copy of the
limited liability company’s federal, state and local income tax
returns for each year;
. . . .
(5) True and full information regarding the amount of cash
and a description and statement of the agreed value of any
other property or services contributed by each member and
which each member has agreed to contribute in the future,
and the date on which each became a member; and

(6) Other information regarding the affairs of the limited
liability company as is just and reasonable.

 6 Del. C. § 18-305(a). The inspection right is subject to “such reasonable standards(including standards governing what information and documents are to be furnished . . . ) as may be set forth in a limited liability company agreement or otherwise established by
the manager.” Id.

The rights of Sanders were co-extensive with Section 18-305 of the LLC Act because the LLC Agreement did not limit those rights. The Court observed that the extensive case law surrounding the rights of a shareholder to books and records of a corporation under DGCL Section 220 are often considered by analogy in the LLC context. Likewise, the following basic rules apply:

  • There must be a "proper purpose" for the inspection;
  • That proper purpose must be reasonably related to such person’s interest as a member;
  • The requested books and records must be reasonably required to fulfill the stated purpose.

Delaware cases have established several proper purposes in this context, including:

  • valuation of one’s ownership interest
  • investigation of potential wrongdoing and mismanagement. Note that in order to satisfy this proper purpose, one need not prove wrongdoing. Rather, it suffices in this context to merely present a "credible basis" to suspect wrongdoing and from which the court may "infer" wrongdoing that would warrant further investigation.

In this case, the Court explained that wrongful dilution that benefits a majority holder establishes a credible basis from which the Court can infer that further investigation is warranted.

The Court also remarked that the data received need not be used to file a derivative suit and that it may also be used, for example, to "communicate with … management" and to determine whether to retain or dispose of one’s interest.

A core inquiry in these types of cases is whether the documents requested are "essential and sufficient" to satisfy the party’s stated purpose. See footnote 2 and related text that comments on the lack of precision in these words that are used by the courts in these types of matters, and what the Court calls the "strange" choice of  "bi-partite phrasing".

Among the documents that the Court determined were reasonable to request in order to advance the stated purpose, were minutes of meetings that discussed the number and pricing of the units issued, and records relating to any opportunity that Sanders had to buy the units at the same price. The Court cited to cases in the Section 220 context to support its decision to allow the records requested for a period prior to the date that Sanders became a member because the records from that earlier period obviously had an impact, for example, on the value of the fully diluted units he currently owned.

Postscript

Although the result of this case may be a positive one for the member seeking the books and records, it may also be described in some ways as a Pyrrhic victory, for several reasons. First, the opinion describes the litigation that was initiated in Illinois by the member way back in November 2007 in his first attempt to address the issues involved. Now, over three (3) years later he obtains some judicial relief–but the story does not end there. The member still does not have the documents. I suspect that there is a good chance that the LLC will not be forthcoming in a prompt and complete manner with all the documents they are required to produce pursuant to this opinion. To the extent that the opinion requires "categories of documents" there is plenty of opportunity for the company to engage in Fabian tactics. I’m not in any way suggesting that the company in this case will do so. I’m simply commenting based on my experience that if the company did so, it would not be unprecedented.

The takeaway, in my view, about these cases, is that requests by members or shareholders for books and records are not for the faint-hearted and are not for those who do not have the financial stamina, or the financial tenacity to spend considerable sums in legal fees to pursue litigation if the company is determined to make the process as expensive as possible, especially in light of the American Rule pursuant to which each party pays its own fees, regardless of who wins the case.