Auriga Capital Corp. v. Gatz Properties LLC, C.A. No. 4390-CS (Del. Ch., Jan. 27, 2012), read opinion here.

What this Case is About and Why it is Important

This case establishes a high-water mark in terms of providing the most comprehensive explanation, based on legislative history and a review of Delaware cases, to explain why the default standard in the LLC context is that fiduciary duty principles will apply to managers of an LLC unless those duties are expressly and clearly limited or eliminated in an LLC agreement.  Prof. Larry Hamermesh, Director of the Institute of Delaware Corporate and Business Law, comments on the decision here. Professor Ann Conaway provides her insights on this opinion here.

UPDATE: On Nov. 7, 2012, the Delaware Supreme Court affirmed the conclusion of this case but eviscerated what it described as dictum to the extent this opinion addressed the issue of default fiduciary dutes for LLCs. The net result of the Supreme Court decision is that as of November 7, 2012, it is an open question in Delaware whether default fiduciary duties exist in the LLC context in the absence of a clear waiver in the LLC agreement. [Note, however, that subsequent legislation has settled the matter.]

Background

This case involves claims by the minority members of an LLC against the majority owner and manager of an LLC.  The manager of the LLC was a man named Gatz and the majority ownership of the LLC was held by him and his family.  He and his family owned land in Long Island that they developed into a public golf course.  They entered into a long term lease with a national golf course management company that managed the golf course.  The LLC and its investors were intended to be passive. Shortly after the venture got started, however, the golf course management company was purchased by a private equity firm who consolidated its various golf courses under management, which resulted in lack of maintenance and poor performance of the golf course involved in this case.  Although the management company had options that extended the lease for 40 years, due to its poor performance, Gatz realized that it was likely to decide to exercise a clause that allowed it to terminate the lease early.  Gatz saw this as an opportunity to “buy back” the golf course at a bargain price and at the same time squeeze-out his minority investors who he came to view as contentious and bothersome intermeddlers.

This 75-page decision provides an extensive description of the background details but among the most important are the documented facts which the Court found, after trial, demonstrated the following:  (i) Gatz knew several years prior to the termination of the lease by the management company that the LLC would either need to be sold or a new management company found to run the golf course; (ii) Gatz, who with family controlled the LLC, and had veto power over any sale, actively discouraged potential bidders and admitted that he wanted to be the only buyer; (iii) He conducted what the Court described as a sham auction in which he was the only bidder, and was represented by conflicted counsel who represented him in connection with his status as a manager of the LLC, but also represented him in his capacity as a bidder at the auction; (iv) Gatz failed to provide information to prospective bidders; failed to negotiate with prospective bidders who were interested; and failed to market the LLC and golf course to any buyers who were most likely to be interested; (v) Gatz provided incomplete or misleading information to the minority members regarding the potential buyers who expressed interest; (vi) Gatz threatened to sue the minority members when they expressed their dissatisfaction with the way the auction and sale were being handled; (vii) Gatz failed to preserve relevant electronically stored information and advanced frivolous and constantly changing legal arguments, which justified, in part, the fee-shifting and award of attorneys’ fees based on the bad faith exception to the American Rule.

Legal Analysis

The length of this opinion (at 75-pages long), is not unusual for Chancery opinions, but the reason why this decision may warrant the appellation of magnum opus is based on the breadth and depth of the extensive footnotes that provide, along with the text of the opinion, the most comprehensive treatment to date in any Delaware opinion of the statutory history and construction of those provisions of the LLC Act that provide a basis for the Court’s conclusion that default fiduciary duty standards apply to managers of LLCs in the absence of an expressly, clearly defined elimination or limitation of those duties.  In addition, this opinion includes the most comprehensive review of Delaware case law on the issue of the application of fiduciary duties in the LLC context, that I recall in the decision of any Delaware court.

When I read decisions like this, I wish that Professor Larry Ribstein were still with us.  His untimely passing last month will be especially missed because, as one of the leading experts in the country on alternative entities, and the author of the leading treatise on the topic, we all would have benefited from his analysis of this opinion.  In order to keep this summary at a manageable length, and because this opinion could be the subject of a law review article-length analysis, at this time I am going to merely highlight the most important principles recited in this decision, with reference to the page and footnote numbers in the slip opinion.

Default Fiduciary Duties in the LLC Context

The Court begins its analysis to explain why default fiduciary duties exist in the LLC context, at pages 16 and 17 of the slip opinion.  The Court compared the Delaware General Corporation Law with the Delaware LLC Act, and the fact that the DGCL, like the LLC Act, “does not plainly state” that traditional fiduciary duties of loyalty and care “apply by default.”  But as in the DGCL, the Delaware Supreme Court in the seminal case of Schnell v. Chris-Craft, 285 A.2d 437 (Del. 1971), stated famously that even if a particular action was expressly permissible under the DGCL, it would not necessarily be endorsed by the Court because of the maxim that:  “Inequitable action does not become legally permissible simply because it is legally possible.”  Id. at 439.  See also Section 18-1104 of the LLC Act which provides that:  “In any case not provided for in this chapter, the rules of law and equity . . . shall govern and underlying rules of law and equity shall govern.”  (emphasis in opinion.)  See footnote 65 regarding the basis for default fiduciary duties.

Definition of Fiduciary Relationship

The Court described the types of relationships that can be defined as fiduciary relationships, and explains why managers of an LLC easily qualify under this category.  Under Delaware law:  “a fiduciary relationship is a situation where one person reposes special trust in and reliance on the judgment of another, or where a special duty exists on the part of a person to protect the interest of another.”  See footnote 35.  See also footnote 38 (citing a Delaware case that found that even a limited partner, who did not manage the business, based on the facts of that case, did owe a fiduciary duty.)

History and Statutory Construction of the Delaware LLC Act

The Court explains the amendments to the LLC Act which currently allow for the elimination and limitation of fiduciary duties except it does not allow for the waiver of the implied duty of good faith and fair dealing.  After citing to the various amendments and the older version of the LLC Act that preceded the amendments, the Court asks the simple rhetorical question:  If the statute was amended to allow for the elimination by contract of fiduciary duties, and if default fiduciary duties did not otherwise apply, then why was there a need to allow one to eliminate those duties by contract?  See page 20.

Overview of Case Law on Fiduciary Duties in an LLC and other Alternative Entities

The Court reviews the Delaware decisions that have addressed the application of equitable principles in the alternative entity context.  The Court concludes that the current status of Delaware case law supports the application of fiduciary duty principles to managers of an LLC unless the parties have eliminated or limited those fiduciary duties.  See footnotes 50 through 53.  The Court further explains why it would be a mistake to expand the concept of the implied duty of good faith and fair dealing to confuse it with the separate fiduciary duties of loyalty and care.  See slip op. at 22 and footnotes 54 to 59.

Affirmative Aspects of Fiduciary Duty of Loyalty

The Court explains that in some contexts there is a duty to take affirmative steps to fulfill the duty of loyalty and those affirmative aspects, which apply outside the alternative entity context as well, are explained at footnote 88 with respect to the LLC context.

Fiduciary Duty toward Minority and Nuances of Fiduciary Duty to Deal Fairly

The Court explained that the duty of a fiduciary to deal fairly requires that the fiduciary “not time or structure a transaction to manipulate the corporation’s value, so as to permit or facilitate the forced elimination of the minority stockholders at an unfair price.”  See footnote 101.

Nor, the Court emphasized, may a fiduciary “play hardball” with those to whom he owes fiduciary duties.  For example, this means that a fiduciary may not use his power to coerce the minority into economic submission.  See footnote 137.  The law of Delaware provides recourse against disloyal fiduciaries or controllers who use their power to coerce the minority into economic submission.  See slip op. at 52.  The Court cited to a Chancery decision at footnote 137, from 1923, that was summarized by the Court for the principle that:  simply because a majority finds a source of its power in a statute, “supplies no reason for clothing it with a superior sanctity, or vesting it with the attributes of tyranny.”

When the powers of a fiduciary are used in such a way that it violates principles prohibiting its oppressive exercise, “it is the special province of equity to assert and protect, and its restraining processes will unhesitatingly issue.”

Damages and Remedies for Breach of Fiduciary Duty

When a breach of fiduciary duty is established, uncertainties in determining damages are resolved against the wrongdoer.  See footnote 156.  Moreover, the Court observed that a defendant whose wrongful conduct has rendered difficult the ascertainment of the precise damages suffered by the plaintiff, is not entitled to complain that they cannot be measured with the same exactness and precision as would otherwise be possible.  See footnote 160.  See also footnote 183 explaining the basis of shifting attorneys’ fees as part of the damages for breach of fiduciary duty.

Fee Shifting

The Court explains, beginning at page 71 of the slip opinion, why it partially shifted fees based on the bad faith exception to the American Rule, and also as part of its remedy for breach of fiduciary duty.  See footnotes 172 to 176.  The Court had scathing language for the conduct of both Gatz and his counsel which the Court described as making the case unduly expensive for minority members to pursue.  The Court also criticized the frivolous arguments such as the assertion that there were no fiduciary duties owed at all.

The Court explained the basis for applying the bad faith exception to the American Rule which provides that each party is ordinarily responsible for its own litigation expenses.  The Court cited many cases to support its decision to depart from the American Rule.

Attorneys’ Fees Imposed in Part due to Failure to Preserve Electronically Stored Information (ESI)

The Court suggested that one of the reasons it was imposing fees on the defendant was due to Gatz’s failure to preserve electronically stored information (“ESI”).  The Court also observed that Gatz may not have been adequately counseled by his legal advisors and as a result deleted relevant documents while litigation was either pending or highly likely.  See footnote 182.

The Court also quoted from the transcript of its questioning of the attorney for Gatz, who said that he did not get the hard drives himself but relied on the client to copy the hard drives.  The Court criticized Gatz and its counsel for “creating evidentiary uncertainty” by “leaving to Gatz himself the primary role of collecting responsive documents.”  Slip op. at 72.  The Court quoted from pre-litigation letters from counsel for Gatz which threatened litigation, and based on the post-trial opinion, were not grounded in sound legal analysis.

The Court explained one of the reasons for its shifting of fees as follows:  “In cases of serious loyalty breaches, such as here, equity demands that the remedy take the reality of litigation costs into account, as part of the overall remedy, less the plaintiffs be left with a merely symbolic remedy.”  See cases cited at footnote 183.

Amount of Fees Awarded

In a final and colorful footnote, the Court explained that the attorney for the winning minority plaintiffs should submit an affidavit setting forth the amount of his fees, and that if counsel for Gatz objected, counsel for Gatz would need to “fully produce their own billing records in full in support of an argument that the minority members’ bills are too high.”  The Court also suggested that it would be an uphill battle with the following closing lines of the footnote:  “In objecting to the amount of the fee, Gatz and his counsel should remember that it is more time-consuming to clean up the pizza thrown at a wall than it is to throw it.” [The Court’s  subsequent decision on the amount of fees was highlighted on this blog here.]

Supplement: Predictably, this epic decision has attracted substantial commentary. In addition to the commentary linked above, for example, Peter Mahler on his New York Business Divorce blog, provides an analysis from a New York perspective, and Seattle lawyer Doug Batey on his LLC Law Monitor blog provides a more national perspective. Postscript: Kevin Brady and Francis Pileggi discuss this case in a LexisNexis videocast available here.

Brenner v. Albrecht, C.A. No. 6514-VCP (Del. Ch. Jan. 27, 2012), read opinion here.

Issue Addressed

The issue addressed in this case was whether a derivative action in Delaware should be stayed or allowed to proceed despite a related, pending federal securities class action.

Background

The plaintiff claimed in this derivative action that the directors and certain officers of SunPower breached their fiduciary duties by failing to implement or to monitor an effective internal control system, which caused the company to misstate, and then to restate, its financial statements for 2008 and 2009.  The restatement led to related actions in federal court accusing the company and its directors of violating federal securities laws, and a class action that is still pending.  This derivative action seeks indemnification for whatever losses the company ultimately incurs in the class action and recovery of other damages related to the restatement.

Analysis

The Court discussed the standard that applies to its exercise of discretion in determining whether to grant a stay in light of pending related actions.  The Court also reviewed the factors that it considers when presented with such a motion.  See footnotes 17 to 19.  The Court also relied on the Delaware Court of Chancery decision in Brudno v. Wise, 2003 WL 1874750 (Del. Ch. 2003).

The Court reasoned that the pending class action would need to address similar issues as arise in this case.  In the course of its analysis, the Court reviewed the familiar elements of a Caremark claim which would need to be established if this case were allowed to proceed.  See footnotes 22 to 24.

In addition to other reasons explained in the opinion, the Court decided that granting the stay was appropriate although it allowed an opportunity for the plaintiff to revisit the issue and submit a new motion “for good cause shown” based on any unforeseen development, and any unexpected burden that the stay might cause.

Cambium Ltd. v. Trilantic Capital Partners, No. 363, 2011 (Del. Supr, Jan. 20, 2012), read Order here.

This Order of the Delaware Supreme Court applied the recent decision of Delaware’s High Court in the Central Mortgage case in which it clarified that Delaware has not adopted the federal standard for motions to dismiss under Rule of Civil Procedure 12(b)(6) as described in the U.S. Supreme Court’s Twombly and Iqbal decisions, despite the truism that the Delaware Rules of Civil Procedure are generally based on the Federal Rules of Civil Procedure. The recent Delaware Supreme Court decision in Central Mortgage taking this position was highlighted here.  The foregoing summary also includes links to other commentary on this blog about this issue.

The recent Court of Chancery decision in the Winshall case responded to the clarification in the Central Mortgage case, especially in an expansive footnote 23, as noted here.  The Delaware Supreme Court in its Order described the Delaware standard for a motion to dismiss under Rule 12(b)(6) as:

 … a “minimal” one. In Central Mortgage, comparing Delaware’s “conceivability” standard to the federal  “plausibility” standard, this Court explained that the former “is more akin to possibility while the federal plausibility standard falls somewhere beyond mere possibility but short of probability.”

In a post-trial decision, the Court of Chancery in Dweck v. Nasser, C. A. No. 1353-VCL (Jan. 18, 2012), found that Dweck, the former CEO, a director and 30% stockholder in Kids International Corporation (“Kids”), and Kevin Taxin, Kids’ President, breached their fiduciary duties of loyalty to Kids by establishing competing companies that usurped Kids’ corporate opportunities and converted Kids’ resources. 

The Court also found that Dweck breached her fiduciary duties by causing Kids to reimburse her for hundreds of thousands of dollars of personal expenses and that Bruce Fine, Kids’ CFO, breached his fiduciary duties by abdicating his responsibility to review Dweck’s expenses and signing off on them. 

UPDATE: A subsequent Chancery decision in this case was highlighted here.

This summary was prepared by Kevin F. Brady.

Background

The background to this case is long and complex as shown by the trial logistics – five-day trial, 930 exhibits, almost 30 fact and three expert witnesses.  As a result, I will only provide a high-level summary of the facts here. In 1993, Dweck and Nasser (Chairman and controlling shareholder of Kids) and others purchased the assets of EJ Gitano. As part of the transaction, Kids was formed and designated for tax purposes as a Subchapter S Corporation so Kids’ profits would be attributed pro rata to Kids stockholders (originally only Nasser). In 1994, Taxin joined Kids as Vice President of Sales and Merchandising, and Kids’ sales subsequently increased by a factor of five over a four-year period.  Around 1998, Dweck was issued 45% of Kids’ outstanding equity.  However, Dweck believed she was not being adequately compensated and so in October 2001, she formed Success Apparel LLC (“Success”), to operate as a wholesaler of children’s clothing.
From 2001 until 2005, Success operated out of Kids’ premises using Kids’ employees. Success drew on Kids’ letters of credit, sold products under Kids’ vendor agreements, used Kids’ vendor numbers, and capitalized on Kids’ relationships.  Then in June 2004, Dweck founded Premium Apparel Brands LLC (“Premium”), a clothing wholesaler, which also operated out of Kids’ premises, and used Kids’ employees and resources. Dweck owned 100% of Premium and served as its CEO. Between 2002 and 2005, Dweck charged almost $500K in expenses to Kids and at least $172K were personal expenses, including vacations and assorted luxury goods.  In March 2005, Dweck admitted at a stockholder meeting that she was selling “overlapping product” and competing with Kids from Kids’ premises. However, Dweck continued to work out of Kids’ offices until April 11, 2005, and Dweck and Taxin continued  to divert Kids’ business to Success.  Dweck and Taxin also arranged for a mass exodus of Kids’ employees to join Success.

Eventually there was a falling out with Nassar and Dweck accusing each other of breaching their fiduciary duties (Nassar also asserted third-party claims against Taxin and Fine).   Nasser sought damages equal to Kids’ purported going-concern value at the time of the split, which his expert values at between $70.8 million and $458.2 million.

Analysis

The Court found that Dweck, as a director and officer of Kids and Taxin as an officer of Kids, each owed a duty of loyalty to Kids and that they breached their duty of loyalty by diverting what they decided were “new opportunities” to Success and Premium.  Dweck and Taxin used Kids’ personnel and resources to pursue each opportunity, demonstrating that Kids just as easily could have pursued the opportunities in its own name. After appropriating the opportunities, Dweck and Taxin operated Success and Premium as if the companies were divisions of Kids, but kept the resulting profits for themselves.  By doing so, Dweck and Taxin placed themselves “in a position inimicable to [their] duties to [Kids].”

The Court provided eminently quotable well-established law on the fiduciary duty of loyalty and the corporate opportunity doctrine:

The essence of a duty of loyalty claim is the assertion that a corporate officer or director has misused power over corporate property or processes in order to benefit himself rather than advance corporate purposes.” Steiner v. Meyerson, 1995 WL 441999, at *2 (Del. Ch. July 19, 1995) (Allen, C.).  At the core of the fiduciary duty is the notion of loyalty–the equitable requirement that, with respect to the property subject to the duty, a fiduciary always must act in a good faith effort to advance the interests of his beneficiary.” US W., Inc. v. Time Warner Inc., 1996 WL 307445, at *21 (Del. Ch. June 6, 1996) (Allen, C.). Most basically, the duty of loyalty proscribes a fiduciary from any means of misappropriation of assets entrusted to his management and supervision. Id. The doctrine of corporate opportunity represents . . . one species of the broad fiduciary duties assumed by a corporate director or officer.” Broz v. Cellular Info. Sys., 67 A.2d 148, 154 (Del. 1996).

The Court also rejected various defenses raised by Dweck and Taxin.  Dweck and Taxin tried to distinguish the new line of business they were entering into from Kids’ line of business.  However, the Court rejected that argument noting that “[w]hen determining whether a corporation has an interest in a line of business, the nature of the corporation’s business should be broadly interpreted. ‘[L]atitude should be allowed for development and expansion. To deny this would be to deny the history of industrial development.’”  Dweck also argued that Nasser gave Dweck permission to compete with Kids but the Court failed to find Dweck’s version of what occurred to be believable. 

Dweck also argued that an operating agreement which contained a so-called “free-for-all” provision authorized her to compete with Kids.  The Court rejected Dweck’s reading of the operating agreement and as to any ambiguity in the agreement, regarding the parties’ course of performance, the Court noted:

It is a familiar rule that when a contract is ambiguous, a construction given to it by the acts and conduct of the parties with knowledge of its terms, before any controversy has arisen as to its meaning, is entitled to great weight, and will, when reasonable, be adopted and enforced by the courts.  Radio Corp. of Ain. v. Phila. Storage Battery Co., 6 A.2d 329, 340 (Del. 1939).  The evidentiary record reflects that before this litigation, the parties did not believe that the essential free-for-all provision granted Dweck the right to compete with Kids. Dweck repeatedly sought to have Nasser sign the Kids stockholders’ agreement, each draft of which contained a functionally identical free-for-all provision. Nasser refused to sign the draft agreements, specifically objecting to the free-for-all provision. Before founding Success and taking the Bugle Boy opportunity, Dweck sought Nasser’s consent (albeit in a vague and ambiguous manner). She received approval only after assuring Shiboleth that her new business would not compete with Kids. If the Essential agreement operated as Dweck now contends, then she had no reason to seek Nasser’s consent.

The Court determined that with respect to the damages for usurping Kids’ corporate opportunities, Dweck, Taxin, Success, and Premium were jointly and severally liable to Kids for the lost profits Kids would have generated from business diverted to Success and Premium between January 1, 2005 and May 18, 2005, which were over $9M.  In addition, among other things, the Court found that Dweck, Taxin, Success, and Premium were also jointly and severally liable for profits generated by Success and Premium after May 18, 2005. This analysis may also be relevant in covenant not to compete cases. See, e.g., Slip op. at 36.

With respect to the mass departure of Kids’ employees and the taking of Kids’ property and files, the Court found that Dweck actively conspired with Taxin and Fine, thereby aiding and abetting Taxin and Fine’s breaches of fiduciary duty.  As a result, the Court found that Kids’ remedy for the departure-related breaches of fiduciary duty should be limited to the damages Kids suffered over and above where Kids would have been had Dweck and Taxin resigned in an appropriate manner. The Court then awarded Kids the profits generated by Success in its non-branded business for the Holiday 2005 and Spring 2006 seasons.

Liability of Officers for Breach of Fiduciary Duty (Approving Personal Expenses of Superior to be Paid by Company Funds)

Finally, with respect to the personal expenses, the Court found Dweck liable to Kids for a total of $342,366 in expenses, comprising both the $171,966 of admittedly personal expenses and the $170,400 of indeterminate expenses.  The Court also found that Fine was jointly and severally liable for those amounts because Fine co-signed for the reimbursement of Dweck’s personal expenses, and he admitted at trial that he did not perform any review of Dweck’s expenses before co-signing her reimbursement checks. See generally, Slip op. at 37-40.

As proven by this case and at least one other prior Chancery opinion cited in this opinion, an officer who approves personal expenses of a superior, which are to be paid with company funds, faces an unenviable binary choice: risk losing one’s job by refusing to process the reimbursement of personal expenses as requested by the superior, or risk personal liability in a court proceeding for approving those expenses in violation of the officer’s fiduciary duty to the company. 

Commentary on Credibility

There is an important theme that the Court mentions a number of times in the opinion that has to do with witness credibility especially in fiduciary cases.  While every litigator know that a witness (and their lawyer’s) credibility is very important, it is worth a reminder now and again.  It is also important to remember that credibility does not just come into play at trial.  It starts at the very beginning of the case with the filing of the complaint and motion practice especially in  discovery disputes before the Court of Chancery.  A good example of this comes from Vice Chancellor Laster’s comments in Eagle Rock when he was dealing with a discovery dispute as to whether an individual should be trusted to identify, preserve, review, and produce relevant electronically stored information.  His larger concern went to the trustworthiness and credibility of an individual who was involved in the litigation and whether he/she should be trusted to do the right thing (in the Eagle Rock case he said that they shouldn’t be trusted to do that without a lawyer being present.)       

Postscript: Professor Gordon Smith blogged about the case here, with scholarly insights on the “free for all” clause that can attempt to eliminate a corporate opportunity claim. See DGCL Section 122(17).

Trilogy Portfolio Company, LLC v. Brookfield Real Estate Financial Partners, LLC, C.A. No. 7161-VCP (Del. Ch., Jan. 13, 2012), read opinion here.

Issue Addressed

Whether the restructuring of a $2.7 billion mortgage loan secured by the Atlantis Resort and Casino in the Bahamas created the necessary type of irreparable harm to the lenders which warranted a TRO.

Short Answer:  Yes.

Background

The creditors of a multi-billion dollar loan secured by the Atlantis Resort and Casino in the Bahamas sought expedited injunctive relief to stop a proposed restructuring of a loan which would forgive the debt owed to the junior-most note holders in exchange for an 100% equity interest in the borrower.  Holders of the more senior notes claim that the proposed transaction would unfairly benefit the junior holders of the debt at the expense of the more senior holders and in direct contravention of the terms of the agreements controlling the debt.  The senior holders also sought a TRO on the basis that they would suffer irreparable harm based on the loss of certain rights and the loss of certain guarantees under the terms of the proposed new loan.

This 23-page decision provides a thorough summary of the multiple parties involved and the different layers of creditors and how each of them would be impacted by the proposed transaction.

Procedural History

The verified complaint in this action was filed on January 4, 2012, along with motions for TRO and expedited proceedings.  Responses were filed on January 9, 2012 and a reply brief by the plaintiff was filed on January 10, 2012.  The Court heard oral argument on the TRO motion on January 11, 2012.

Contentions of the Parties

Plaintiffs argued that the proposed transaction was unfair to the creditors and that the proposed loan restructuring would provide a valuable equity interest in the borrower while unfairly transferring substantial risk to the other creditors.  The plaintiffs alleged that the restructuring would violate contractual rights, as well as breach fiduciary duties.

Analysis

The Court recited the familiar prerequisites that need to be satisfied for a TRO and its “less exacting” scrutiny based on the limited factual record generally available at such an early stage of an expedited proceeding.  See footnotes 7 through 12. 

Contrast this standard, however, with a factual record that is more fully developed, in which event “the traditional temporary restraining order standard is not fully applied and the Court considers whether there is a probability of success on the merits.”  See footnote 13.  In this case, the Court found that the plaintiffs satisfied the prerequisits for a TRO.  The Court required a bond pursuant to Court of Chancery Rule 65(c) in the amount of $100,000 secured, and rejected the request of the defendants that the bond be in the amount of $230 million.

The Court scheduled a preliminary injunction hearing for January 27, 2012, and made the TRO effective immediately.

 

On January 13, 2012, the Court of Chancery issued non-binding guidelines or “best practices” to help lawyers and their parties handle common and sometimes complex  procedural issues that arise in litigation before the Delaware Court of Chancery. 

Kevin F. Brady, who is a member of the Court of Chancery Rules Committee, prepared this summary.

The 18-page Guidelines cover a variety of topics from as simple as hearing protocols, courtesy copies, contacting Chambers and scheduling expedited or summary proceedings to more expedited subjects such as expert report and confidentiality agreements.  The Guidelines also include sample forms for such proceedings as scheduling a preliminary injunction, a Rule 12(b)(6) motion or cross-motions for summary judgment. 

The Guidelines, available for download here, include procedures that the Court would prefer to see.  For example, with respect to expert reports, the Guidelines state:

In general, the Court prefers that parties stipulate to limit expert written discovery to the final report and materials relied on or considered by the expert. Counsel should be aware that the Court understands the degree of involvement counsel typically has in preparing expert reports. Cross-examination based on changes in drafts is usually an uninformative exercise.

With respect to the pleadings, the Guidelines state: “An answer should repeat the allegations of the complaint and then set forth the response below each allegation. Otherwise the Court has to look back and forth from answer to complaint to see what is being denied.”

One of the more important guidelines issued by the Court provides instruction to the legions of non-Delaware lawyers who coordinate with local Delaware lawyers to litigate cases in Chancery. About these working relationships, the Court gives the following specific direction:

Role of Delaware Counsel

a. The concept of “local counsel” whose role is limited to administrative or ministerial matters has no place in the Court of Chancery. The Delaware lawyers who appear in a case are responsible to the Court for the case and its presentation.

b. If a Delaware lawyer signs a pleading, submits a brief, or signs a discovery request or response, it is the Delaware lawyer who is taking the positions set forth therein and making the representations to the Court. It does not matter whether the paper was initially or substantially drafted by a firm serving as “Of Counsel.”

c. The members of the Court recognize that Delaware counsel and forwarding counsel frequently allocate responsibility for work and that, in some cases, the allocation will be heavily weighted to forwarding counsel. The members of the Court recognize that forwarding counsel may have primary responsibility for a matter from the client’s perspective. This does not alter the Delaware lawyer’s responsibility for the positions taken and the presentation of the case.

d. Non-Delaware counsel shall not directly make filings or initiate contact with the Court, absent extraordinary circumstances. Such contact must be conducted by Delaware counsel.

e. It is not acceptable for a Delaware lawyer to submit a letter from forwarding counsel under a cover letter saying, in substance, “Here is a letter from my forwarding counsel.”

Finally, there are some interesting comments with respect to what counsel should include in Compendiums and Appendices.  The Guidelines show that this is an opportunity to point the Court to exactly what counsel want the Court to review.  There is also a humorous comment where the Guidelines tell counsel they don’t have to include everything in a compendium – “Avoid the Manhattan Phonebook. If a submission is huge, uncomfortable to hold, and likely to fall apart, please break it into separate usable volumes.”

As the Court stated in its announcement:

The goal of the guidelines is to help litigants deal with each other and the Court in a more constructive, less contentious, and therefore more efficient and just manner. … All the members of the Court recognize the guidelines as sound and members of the Court will endeavor to avoid the chambers-specific approach that results in litigants having to address the idiosyncratic preferences of multiple members of the same court.  All of us on Chancery recognize how challenging it is for lawyers to address complex cases especially in view of evolving issues such as electronic discovery, said Chancellor Leo E. Strine, Jr.  By developing these practice guidelines with the invaluable help of our Rules Committee, we hope to make our Bar’s life a little easier and to enable all of us to concentrate more on the merits, rather than procedural jousting. This will get cases resolved less expensively and faster.

The Guidelines are the product of a joint effort between the judges of the Court of Chancery and the Court’s Rules Committee, which is comprised of experienced Delaware practitioners.  Please note that this is not the end of the guidelines for the Court of Chancery.  The Rules Committee is working on other rules and procedures, so stay tuned for more information.

Professor Steven Davidoff provides scholarly and statistical analysis of M & A litigation in a recently published article, in which he also addresses the issue of whether Delaware is “losing” that type of litigation to other states, and related aspects of this topic. His article entitled: “A Great Game: The Dynamics of State Competition and Litigation“, with University of Notre Dame professor Matthew D. Cain, is available here. The abstract explains as follows:

       We provide a multi-dimensional picture of jurisdictional competition for corporate litigation by examining merger litigation in a hand-collected sample of 955 takeovers from 2005-2010. We find that entrepreneurial plaintiffs’ attorneys drive this competition by bringing suits in jurisdictions which have previously awarded more favorable judgments and higher fees and by avoiding unfavorable jurisdictions. States with an interest in attracting corporate litigation respond in-kind by adjusting judgments and awards to re-attract litigation. Competing states award higher attorneys’ fees and dismiss fewer cases when attorneys have been migrating to other jurisdictions. Our findings illuminate the dynamics of jurisdictional competition for corporate litigation.

The good professors have also released preliminary statistics for takeover litigation in 2011 in a six page report available here. The highlights they provide are as follows:

Highlights from 2011:

** Delaware Attracts Highest Rate of Litigation in 7 Years

** Takeover Litigation Continues to Increase

**Lawsuits Brought in 94% of Takeovers versus 85% in 2010

** Half of Transactions Have Lawsuits in Multiple States

** Average Attorneys’ Fee Awards Decline by 27%

Shiftan v. Morgan Joseph Holdings, Inc., C.A. No. 6424-CS (Del. Ch. Jan. 13, 2012), read opinion here.

Issues Addressed:

(i)         Whether the Court may consider in an appraisal action a contractually required redemption event in the certificate of incorporation, scheduled to occur six months after the merger, in determining the fair value of the stock;

(ii)        Whether the automatic redemption provision was subject to an “excess cash” requirement in the certificate of incorporation.

Short Answers:

(i)         The Court concluded that it was appropriate to consider the automatic redemption for purposes of the appraisal analysis even though the merger occurred several months before the right was triggered.  The Court distinguished this redemption right from cases in which the Court has refused to consider speculative possibilities in rendering an appraisal opinion, or where preferred stockholders were contractually told how their shares would be treated in the event of a merger;

(ii)        The Court also found that the automatic redemption was not subject to an “excess cash requirement” under the certificate.  The certificate of incorporation was plain that there were two types of redemptions for preferred stock.  In addition, although the Court found that the certificate was unambiguous, parol evidence also supported the conclusion in favor of the petitioners.  The Court especially noted that Morgan Joseph chose not to file a Rule 56(f) affidavit or to submit any conflicting parol evidence.

Background

The defendant in this case, Morgan Joseph Holdings, Inc., is an investment bank in which the petitioner held Series A Preferred Stock.  The petitioners bought their preferred stock when Morgan Joseph was founded in 2001 to help provide the initial funding for the company.  In December 2010, Morgan Joseph merged with another investment bank called Tri-Artisan Capital Partners, LLC.  The new Series A Preferred Stock which was governed by a new certificate of incorporation, was offered in exchange for Morgan Joseph’s old Series A Preferred Stock.  Instead of exchanging their Series A Shares, the petitioners in this action demanded appraisal under 8 Del. C. § 262. 

The certificate of incorporation included a provision for an automatic redemption of the Series A Preferred Stock at $100 per share which would have been triggered six months after the merger.  The petitioners claimed that because their stock was to be mandatorily redeemed six months after the merger, the Court should take into account the $100 per share redemption value provided for in the certificate in determining the fair value of the Series A Preferred Stock.

Short Summary of Court’s Reasoning

The Court emphasized that “the core mandate of Section 262 requires this Court to award the petitioners the ‘fair value of their shares.’” (emphasis in original) (citing 8 Del. C. § 262(h)).  The Court also emphasized that in the case of an appraisal of preferred stock, the Court must look at the contract rights granted to the shares being appraised under the relevant certificate of incorporation or designation in determining fair value.  In this case, the Court reasoned that the unique contractual feature of the automatic redemption given to the Series A Preferred Stock under the certificate had to be considered in rendering the final appraisal decision.

This decision was made in the context of a motion for partial summary judgment.  The material facts were not disputed, but rather, there was a different interpretation about how the certificate of incorporation provisions should be interpreted in connection with the automatic redemption clause and its impact on the analysis of the fair value in this appraisal proceeding.

The Court conducted an extensive analysis of the language in the certificate of incorporation and applied contract interpretation principles, including the principle of contract interpretation which says that ambiguous terms should be construed against the drafter.  The Latin phrase for that contract interpretation principle is contra proferentem.  See footnotes 17 through 26.

This 23-page opinion also provides helpful analysis regarding the construction of the rights granted to preferred stockholders in a certificate of incorporation or a certificate of designation.

Steinhardt v. Howard-Anderson, C.A. No. 5878-VCL (Del. Ch. Jan. 6, 2012), read opinion here.

Issue Addressed

This opinion addressed the issue of whether representative plaintiffs in a putative class action should be in sanctioned for trading on the basis of confidential information obtained in the litigation.  The motion was granted.

Background

On November 21, 2011, the Court held an evidentiary hearing on the Motion for Sanctions and heard live testimony.  The paper record included depositions, affidavits and additional deposition transcripts and documents from the injunction phase of the case.

This action was originally filed in October 2010 challenging a merger between Occam Networks, Inc. and Calix, Inc.  In November 2010, the Court approved the Stipulation and Order governing the production and exchange of confidential information.  In December 2010, the Plaintiffs moved for a preliminary injunction against the merger and expedited discovery ensued.  After the discovery was nearly complete, Steinhardt began short-selling Calix’s stock.  He intended to and later did use the shares of Calix stock he would receive when the merger closed to cover his short sales, even though Steinhardt and his co-plaintiffs where asking the Court to enjoin the closing of the merger.

According to published reports, Steinhardt has a net worth of approximately $500 million and has been described in some reports as one of the most successful investors in the history of Wall Street.  In January 2011, after a hearing open to the public, the Court granted the Motion of the Plaintiffs for a Preliminary Injunction.  After the issuance of supplemental disclosures and the deposition of one of the lead investment bankers, which were conditions of the injunction, a special meeting of stockholders was held, additional disclosures where made, and the merger was approved in February 2011.

Legal Analysis

The Court emphasized that when a stockholder of a Delaware corporation files suit as a representative plaintiff for a class of similarly situated stockholders, the plaintiff voluntarily assumes the role of a fiduciary for the class.  As a fiduciary, the representative plaintiff “holds to those whose cause he advocates a duty of finest loyalty”.

The Court referred to a long list of Chancery transcript rulings at footnote 1 in which the Court of Chancery has addressed trading by representative plaintiffs, and has explained that trading by plaintiff–fiduciaries on the basis of information obtained through discovery undermines the integrity of the representative litigation process and is unacceptable.  It remains unacceptable for a plaintiff-fiduciary to trade on the basis of non-public information obtained in litigation.  See footnote 3.

The Court explained in detailed reasoning from those transcript rulings, and applied those rulings to the extensively described factual minutiae of the trading involved in this case, based on information obtained during the discovery as representative plaintiff.

Damages for Breach of Fiduciary Duty

The Court explained that the scope of remedy for breach of the duty of loyalty is not to be determined narrowly and that the disgorgement remedy rests upon “ a wise public policy that for the purpose of removing all temptation, extinguishes all possibility of profit flowing from a breach of confidence imposed by the fiduciary relation.”

The Court provided a detailed numerical listing of the trades and the “deemed purchases” in violation of the obligations to maintain the confidentiality of the information received in the litigation.  The Court deducted the implied basis of the stock from the actual sales proceeds to generate a disgorgement amount of approximately $534,000.00.  The Court encouraged the parties to double-check its math and if possible to distribute the funds to the class immediately.

Conclusion

The Court summarized its holding, in part, as follows:

Consistent with prior rulings by this Court when confronted with representative plaintiffs who have traded while serving in a fiduciary capacity, Steinhardt and the funds are dismissed from the case with prejudice, barred from receiving any recovery from the litigation, required to self-report to the Securities and Exchange Commission, directed to disclose their improper trading in any future application to serve as lead plaintiff, and ordered to disgorge profits in the amount of $534,071.45. 

Postscript: Professor Bainbridge provides scholarly insights about the case here.

 

 

In Hosanna-Tabor v. EEOC (download here), the U.S. Supreme Court yesterday recognized a defense that churches may assert against claims by some employees based on anti-discrimination laws, such as a minister that claims she was discriminated against on an issue that comes within the scope of the church’s religious beliefs. Professor Bainbridge comments on this important ruling here; The Wall Street Journal reports on the U.S. Constitutional basis in the opinion (that also cites to the Magna Carta) here, and employment lawyer Daniel Schwartz provides insights here.