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Crothall v. Zimmerman, Del. Supr., No. 608, 2013 (June 9, 2014).

This Delaware Supreme Court decision features a rare reversal of the Court of Chancery, and determined that the award of attorneys’ fees was improvidently granted because there was no corporate benefit in this derivative action.  There was no corporate benefit, the Delaware high court reasoned, because there was no final judgment.  Prior to a final judgment, the derivative plaintiff sold his shares, which led to the dismissal of the case.  This situation should be distinguished from other cases where the defendant took action to make the case moot before a prior judgment.  The Court of Chancery allowed the attorney for the former plaintiff to intervene in order to seek counsel fees.

However, the Supreme Court noted that, although it did not directly rule on the intervention, it was “odd” and “troubling” to permit a lawyer in a representative action to recover from the company in circumstances where the stockholder rendered his claim moot.

The rule announced in this decision that can be applied to future cases is that:  “A plaintiff who generates a favorable trial court decision on a closely contested issue of corporate governance but then abandons his claim, and renders the decision moot before it becomes final, has not created a corporate benefit, he has merely caused uncertainty.”

The reasoning of the court is that no corporate benefit was created because any benefit that might have been possible by continuing the suit to a final, appealable judgment, disappeared when the derivative plaintiff abandoned his lawsuit.  Therefore the former attorney for that plaintiff was not entitled to any fee award.  Nor did that counsel identify any cases in Delaware which held that a plaintiff’s attorneys are entitled to fees for creating a corporate benefit when the plaintiff (as opposed to the defendant) took action that mooted the claims, caused their dismissal, and prevented the entry of a final judgment.

See prior Chancery decisions summarized on this blog in this matter.

 

Zimmerman v. Crothall, C.A. No. 6001-VCP (Del. Ch. Oct. 14, 2013).

This opinion is noteworthy for its reasoning in granting an award of attorneys’ fees based on the corporate benefit doctrine where the benefit conferred on the company by virtue of the underlying litigation is real but not quantifiable.  In such cases, courts have granted attorneys’ fees on the basis of quantum meruit.  See footnotes 68 and 69.  For prior decisions explaining the extensive factual background and claims involved, two prior Chancery decisions in this matter were highlighted on these pages. N.B.: In June 2014, the Delaware Supreme Court reversed this decision.

Zimmerman v. Crothall, C.A. No. 6001-VCP (Del. Ch. Jan. 31, 2013)

Issue Presented 

This 74-page opinion addresses the allegations of a minority unitholder in an LLC who asserts claims that the directors breached their fiduciary duties in connection with several financing transactions.

Brief Overview 

Zimmerman claimed that the challenged transactions should be analyzed under the entire fairness standard of review based on the actual control by a majority of the directors interested in the challenged transactions and who received an exclusive benefit, but in any event, Zimmerman argued unsuccessfully that the directors could not demonstrate the fairness of the transactions which were alleged to be a violation of their duty of loyalty.  Zimmerman also claimed that the transactions did not receive the necessary approval from all of the members.  See prior Chancery decision in this matter summarized on these pages here.

The Court concluded after a three-day trial and post-trial briefs that even though a declaratory judgment would be entered that the directors exceeded their authority in engaging in the financing transactions, the Court found that the directors’ breach did not cause any damages.  The Court also ruled that the directors were entitled to both advancement and indemnification, notwithstanding the breach by the directors of the LLC operating agreement.

The Court provided an extensive description of the applicable law for interpreting an ambiguous contract such as the one involved here.  The Court also observed that the applicable statute, the Delaware LLC Act, allows parties wide latitude in crafting an agreement customized to their needs.  See pages 21 and 22.  For example in this case, the LLC Agreement involved the issuance of ownership interests in units as opposed to admitting members, and it also incorporated certain corporate law terms, such as a board of directors.

The Court discusses in extensive detail under what circumstances additional units can be issued under the LLC Agreement.  The Court noted that the LLC Act establishes “no formalities that must be observed for the creation and issuance of limited liability company interests,” as opposed to the analogous situation in a corporate context.  See footnote 100 and accompanying text.

The Court concluded that the board breached the operating agreement in undertaking each of the challenged transactions regarding the issuance of additional units.

The Court explained that in determining the contractual intent of the parties, the “true test is not what the parties to the contract intended it to mean, but what a reasonable person in the position of the parties would have thought it meant.”  See footnote 117.  The Court also applied the rule that construing and ambiguous contract against the drafter is appropriate based on the rule of contra proferentum.

The Court considered the breach of duty of loyalty claims that were based at least in part on the argument that certain unitholders owed fiduciary duties in light of their controlling interest.  The Court described the case law that determines when an interest in an entity will be considered controlling, even if it is less than 50% or when actual control over a board takes place in the course of a particular transaction.  See footnote 129 and accompanying text.

However, the Court found that the parties involved “neither acted together nor were connected in some legally significant way” so that they were not acting in concert in a manner that was sufficient to establish control.  Because the Court concluded that the two unitholders were not acting in concert or otherwise exerting “actual control” over the board, there was no basis for the breach of fiduciary duty claim that rested on the finding of a control group of shareholders.

The Court next considered the fiduciary duties under the terms of the operating agreement and found that the operating agreement did provide that the directors of the LLC were fiduciaries.

Importantly, at footnote 145, the Court of Chancery noted that the Delaware Supreme Court has not yet “definitively determined whether the LLC statute imposes default fiduciary duties,” but also cited a more recent decision of the Court of Chancery that held that “subject to clarification from the Supreme Court, managers and managing members of an LLC do owe fiduciary duties as a default matter.”  (citing Feeley v. NHAOCG, LLC, 2012 WL 5949209, at * 8-10 (Del. Ch. Nov. 28, 2012)).

Moreover, the Court found that the fiduciary duties were restricted pursuant to 6 Del. C. Section 18-1101(c) to the extent that the agreement gave the directors the right to engage in transactions with the company.

The Court interpreted the provision of Section 6.13 of the LLC Agreement requiring the transactions with the company be “fair” as “effectively calling for review under an entire fairness standard.”  See footnote 159 (noting that magic words such as “entire fairness” or “fiduciary duties” are not necessary in order to impose fiduciary standards of conduct as a contractual matter).  However, the Court also found that the entire fairness standard was not shown to have been breached.

The Court also observed that the concepts of Section 144 of the Delaware General Corporation Law were incorporated into the LLC Agreement by reference.  Section 144 allows for self interested transactions with the director’s corporation to survive the common law concept that they are voidable.  Although this concept has no analogue in the LLC context; because it was incorporated into the agreement, the Court had to address it.  See footnotes 153 and 154 and accompanying text.  The Court found in this case that the defendants did comply with at least one of the safe harbors in Section 144 that was incorporated into the LLC Agreement by reference.  Thus, because the Court found that the challenged transactions were approved in good faith by informed disinterested directors, and should receive the benefit of the business judgment rule, the Court found that the burden of proof of entire fairness shifted to Zimmerman.  The Court also found the challenged transactions to be fair.

Remedy 

The Court concluded that Zimmerman was entitled to judgment in his favor on the breach of contract claim but not on the breach of fiduciary duty claim.  The appropriate remedy would be to recover damages resulting from the breach of the agreement but the Court determined that the transactions were fair and therefore there were no such damages.

Zimmerman also asked the Court to order defendants to reimburse the company for over $1 million in legal fees that it advanced to the law firm representing the defendants.  The Court reasoned that:

“Whether a party has the ultimate right to an advancement depends on whether his underlying conduct is indemnifiable.” 

(citing Reddy v. Elec. Data Sys. Corp., 2002 WL 1358761, at * 5 (Del. Ch. June 18, 2002)).  The Court found that the agreement required indemnification for the defendants based on the circumstances of this case.  See footnote 210.

Quoting the applicable parts of the LLC agreement, the court explained that even though the defendants breached the agreement, there was no evidence that the breach was the result of willful misconduct or other disqualifications to indemnification contained in the LLC agreement.  In addition to the LLC agreement, “at least some” of the defendants were also parties to separate agreements that also provided for advancement and indemnification.

The trial having been concluded, and the right to indemnification established, the court observed that Zimmerman could have sought a pre-trial ruling on advancement.  Nonetheless, there was no basis for the court to invalidate the board decision to grant advancement which was consistent, the court reasoned, with the LLC agreement’s requirement that the company indemnify its directors “to the fullest extent permitted by law.” See footnotes 216 and 219.

In this post-trial opinion, the right to advancement was largely moot, but the Court explained that even though the operating agreement “does not explicitly address advancement rights,” the board had the authority to approve the advancement of legal fees based on broad authority to make decisions for the company not otherwise provided for in the LLC Agreement.

POSTSCRIPT: FYI, the Court of Chancery wrote a subsequent opinion involving the parties in this case.

Zimmerman v. Crothall,  C.A. No. 6001-VCP (Del. Ch. March 5, 2012; revised March 27, 2012).

Issue Presented

The issue presented was whether the directors breached their fiduciary duties by issuing shares that they bought themselves and which were not available to the same extent to all shareholders. 

Result: The Court of Chancery denied defendant’s motion for summary judgment.

Background

The capital structure of the company involved in this matter was presented in four categories:  (1) Class A Common Units; (2) Class B Common Units; (3) Series A Preferred Units; (4) Series B Preferred Units, which participated pari passu with Series A and is Senior to Class A and Class B Common Units.  Venture capital investors controlled a majority of the company’s Series A Preferred Units.

The facts indicated that the company over the last few years, as a start-up, generated revenues of less than $1 million in the prior two years, but suffered losses of approximately $5 million during that same period.  One of the reasons given for the issuance of several million dollars in additional shares was that there was no other source of financing.

The founder and former CEO challenged the issuances of additional shares claiming that they were self-interested transactions designed to benefit the directors of the company and venture capital sponsors by unfairly diluting its common members.  The defendants moved for summary judgment on all counts.  Although the Court granted summary judgment to the defendants on the duty of care claims, the Court denied the motion regarding the duty of loyalty claims and found that the defendants failed to establish that the transactions were not self-interested.

Legal Analysis
After reviewing the familiar standard for summary judgment, the Court also recited the familiar business judgment standard.  The Court reiterated the requirement that the plaintiff establish a genuine issue of material fact as the whether the directors were “independent, disinterested, and informed or acting in good faith.”  In addition, if a plaintiff meets this burden then the challenged transaction must be reviewed for entire fairness.  The fact intensive demands of such review make it difficult for a defendant to prevail on summary judgment.  See footnote 21 (citing Encite LLC v. Soni, 2011 WL 5920986, at *20 (Del. Ch. Nov. 28, 2011)).

The Court also observed that in order to rebut the presumption that is a benefit of the business judgment rule’s deference, the plaintiff must show that “the directors’ decision was either wholly-irrational or motivated by self-interest or bad faith on the part of the directors approving the transaction.”

Duty of Care Claims

The plaintiff claimed that the transactions at issue were approved in violation of the duty of due care because they were without deliberation (being approved by written consent), and did not consider all reasonably available information.  In connection with its analysis, the Court addressed the use of the word “reckless” in the LLC agreement, and equated the term with the more familiar “gross negligence” standard for breach of the duty of care under Delaware corporate law.  See footnotes 29 to 31.  The Court explained why it relied on prior Delaware caselaw as opposed to the contract interpretation doctrine known as noscitur a sociis, which refers to the concept of understanding words (and people) based on their companions.

The Court explained in this 51-page decision why summary judgment was appropriate on the  duty of care claims.  The Court explained that “under the business judgment rule, scrutiny of a board’s actions begins with the presumption that the directors 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 footnote 36.  The Court also emphasized that whether or not the board was reasonably informed in making a business decision does not mean that the board must be informed of every fact, but instead the board is responsible for considering only material facts that are reasonably available at the time of the decision.  It is not the office of the Court to second guess the reasonableness and prudence of a business judgment.  In order to avoid the application of the rule, plaintiff must allege that “the process applied by a board in making a business decision was so egregious as to constitute reckless indifference to or a deliberate disregard with the whole body of stockholders for actions which are without the bounds of reason.”  See footnote 39.

Especially noteworthy is the Court’s instruction that:  “where a corporation in financial distress issues stock as a means to raise needed capital, its directors are given considerable latitude in fixing a price for the issuance.”  See footnote 47.  The Court noted in this case that the defendant failed to present any expert opinion on valuation (which did not help his case).

Duty of Loyalty Claims

The plaintiff claimed that the issuance of additional shares and the approval by the board members who participated in the purchase of those shares was a self-dealing transaction of bad faith.  It was also alleged that a majority of the directors stood on both sides of the transaction and received an exclusive benefit at the expense of the common members.

Bad Faith 

In order to prevail on a bad faith claim, the plaintiff “must overcome the general presumption of good faith by showing that the board’s decision was so egregious or irrational that it could not have been based on a valid assessment of the corporation’s best interests.”  See footnote 51.  The Court recognized that there is a third “intermediate category” of fiduciary misconduct between subjective bad faith and gross negligence, which is the “intentional dereliction of a known duty.”  See footnotes 52 and 53.  The Court previously found that the transactions were not grossly negligent or reckless; thus, by necessity it determined that the intermediate standard was not successfully plead. 

Self-Dealing

The entire fairness standard will apply where a transaction is approved by a majority of the directors or a controlling stockholder “standing on both sides of the transaction, dictating its terms, and obtaining a benefit not received by all stockholders generally.”  See footnote 53.

In addition to describing those situations in which a shareholder would be deemed controlling, relying on Kahn v. Lynch Communications Systems, Inc., 638 A.2d 1110, 1113 (Del. 1994), the Court found that there was a genuine issue of material fact as to whether or not the venture capital investors together exerted actual control over the company, and therefore the motion for summary judgment on that basis was denied.

The Court found that the majority of the board was either interested or not independent when they approved the challenged transaction.  The Court reviewed each individual director defendant to determine whether they were interested and non-independent.  See footnotes 65 and 66.  After reviewing the definitions as they applied to each member, the Court found that a majority were lacking in independence. 

The Court explained that in order to rebut the presumption of director independence, it does not suffice that the directors “moved in the same social circles, attended the same weddings, developed business relationships before  joining a board, and describe each other as friends.”  Rather, in order to establish lack of independence in considering a corporate transaction, the plaintiff “must make specific allegations of such material connections as financial ties, familial affinity, a particularly close or intimate personal or business affinity, or evidence that in the past the relationship caused the director to act non-independently vis-à-vis an interested director.”  See footnote 72.

The Directors Receive an Exclusive Benefit

In addition to showing that a controlling shareholder or a majority of the board was interested, the plaintiff must also show that “a transaction conferred an exclusive benefit on those interested fiduciaries to prove self-dealing.”  See footnote 73.

Delaware Supreme Court’s Gentile Decision

The Court reviewed the Delaware Supreme Court’s opinion in Gentile that explained that certain claims can be both derivative and direct in the context of an alleged dilution by controlling stockholder.

The money quote by the Court of Chancery is as follows:

“The essential teaching of Gentile is that in situations where a corporation issues successive shares to a controlling shareholder in exchange for an asset of lesser value, minority shareholders can bring both direct and derivative claims.”

That is, Gentile confirms that two types of actions, direct and derivative, can be brought based on the same transaction.

Bottom Line

The Court concluded that the plaintiff properly brought this fiduciary duty claim regarding the alleged overpayments by the company (in connection with the issuance of shares) on at least a derivative basis.  In addition, the plaintiff made a sufficient showing to support a reasonable inference that the transaction conferred an exclusive benefit on defendants, namely the opportunity to buy equity in the company at a price that allegedly is unfair.

The Court also emphasized that to the extent that the transaction was not entirely fair, that issue cannot be decided on a summary judgment motion, based on the factual issues presented.

No Pre-emptive Right

The Court acknowledged that there is no inherent right against dilution under Delaware law.  The court referred to Section 102(b)(3) of the DGCL which provides that no stockholder shall have the pre-emptive right to subscribe to additional issues of stock unless the charter expressly provides.

In this case, the Court found that the director defendants enjoyed an exclusive benefit under the challenged transactions that was not available to everyone generally, and therefore, the transactions were self-dealing and subject to entire fairness.

DGCL Section 144

The Court explained that DGCL Section 144, when its prerequisites are satisfied, fairly removes an interested director cloud so that an agreement cannot be invalidated solely because the director was involved.  However, Section 144, or its analog in the operating agreement in this case, which was based on Section 144, was not intended to address the common law rules for liability or breach of fiduciary duty.  Therefore, even if there was compliance, that would not operate as a safe harbor against the challenge to the transaction under the entire fairness standard.

One final note: the Court explained that “where a breach of fiduciary duty claim overlaps completely” a contractual claim that arises from the same nucleus of operative facts, the contractual claim will control and the courts generally dismiss the fiduciary duty claim.  See footnote 106.