The following article by Kevin F. Brady and Francis G.X. Pileggi first appeared in the June 29, 2011 edition of The Delaware Business Court Insider.

On June 15, the Delaware Court of Chancery dismissed with prejudice a derivative and direct action brought against the board of trustees and the investment management firms that oversaw investments of mutual funds. The shareholders argued that the trustees’ and advisers’ actions constituted a violation of their fiduciary duties, negligence and waste because some of the investments involved illegal foreign online gambling businesses that violated 18 U.S.C. § 1955, which makes it a crime to “own” any part of an illegal gambling business. The case is captioned Hartsel v. The Vanguard Group Inc.

The introductory part of the opinion describes in great detail the rather complex organizational structure of the various Vanguard mutual fund families involved, as well as the overlapping board of trustees and other related entities that provide advisory services. Vanguard is one of the largest mutual funds in the business and the description from a corporate law point of view of the various types of entities and organizational structures of the related mutual funds is illuminating for those interested in how one of the largest mutual fund families is governed.

Interestingly, the different mutual funds held by the nominal defendants are not separate legal entities, rather they are separate mutual funds that form part of a series of mutual funds that are held by each of the nominal defendants. Thus, investors in each of the mutual funds within a specific nominal defendant hold different series of shares in the same legal entity. The nominal defendants are part of a larger mutual fund complex in which there are 34 other separate registered investment companies like them. The two nominal defendants are Delaware statutory trusts based in Wayne, Pa. Each of the trusts contains multiple mutual funds, for each of which a separate class of stock is offered to public investors. The investment companies within the mutual fund complex all share a single board of trustees.

The defendant, the Vanguard Group Inc., is an investment management company organized under the laws of and headquartered in Pennsylvania. It is owned by the investment companies it manages and, importantly, the same board of trustees that oversees each separate mutual fund series in the mutual fund complex also serves as the board of directors for Vanguard. Vanguard provides advisory services to the nominal defendants through one of the principals of Vanguard, who is one of the individual defendants. Additional defendant-entities also provided investment advisory services. Although the intricate organizational structure that binds the defendants is necessary to understand the opinion, based on the space provided for this overview, the details are necessarily limited.

LACK OF PERSONAL JURISDICTION

None of the individual defendants were residents of Delaware and all of them objected to the exercise of personal jurisdiction by the Delaware Court of Chancery, arguing that there was no basis for such jurisdiction under Delaware’s long-arm statute or the Due Process Clause of the Fourteenth Amendment. Plaintiffs disagreed and asserted that jurisdiction was appropriate under both the long-arm statute and the conspiracy theory of jurisdiction, as well as, for defendants Frashure, Chisholm and Wolahan, because they consented to jurisdiction under 6 Del. C. Section 18-109(a).

TWO-STEP APPROACH

The court applied a two-step analysis to determine whether the exercise of personal jurisdiction over a nonresident defendant is appropriate in the context of a motion to dismiss for lack of personal jurisdiction under Rule 12(b)(2). First, the court determines whether there is a basis for personal jurisdiction under the Delaware long-arm statute. Second, if a statutory basis for jurisdiction exists, the court must determine “whether subjecting the nonresident to jurisdiction in Delaware violates the Due Process Clause of the Fourteenth Amendment.” The plaintiff has the burden to prove that both steps are satisfied as to each of the defendants.

IMPLIED CONSENT STATUTE

The court also examined the implied consent statute of Section 18-109(a) of the Delaware Limited Liability Company Act because three of the defendants served as officers of a Delaware LLC that was named as a defendant. The determinative phrase in that statute that was in dispute allows claims against a manager of an LLC in actions “involving or relating to a business of the limited liability company.” The issue is whether that phrase allows a manager to be sued in Delaware in an action that relates the business of the LLC if the allegations in the complaint focus on the rights, duties and obligations the manager owes to his organization and not to external entities, such as the stockholders of a client mutual fund.

The defendants argued successfully that the consent statute did not apply here because the action concerned breaches of duties that allegedly were owed to parties who were not affiliated with the LLC. The court explained that regardless of a literal reading of Section 18-109(a), the wording of the statute had to be limited by the constitutional prerequisites that prohibited the exercise of personal jurisdiction in situations which would “offend traditional notions of fair play and substantial justice.” Due process would not be offended however, if the plaintiffs could show the following three factors: (1) The allegations against the defendant-managers focus centrally on rights, duties and obligations as a manager of a Delaware LLC; (2) The resolution of the matter is inextricably bound up in Delaware law; and (3) Delaware has a strong interest in providing a forum for the resolution of a dispute relating to the managers’ ability to discharge their managerial functions. The allegations in this case did not focus on the duties and obligations the managers owed to the LLC and in that sense, did not relate to the internal business of the LLC as required by both the statute and the Due Process Clause.

CONSPIRACY THEORY OF PERSONAL JURISDICTION

The court explained that this theory of personal jurisdiction is not an independent basis for subjecting a nonresident to personal jurisdiction. Rather, it rests upon the notion that when the conduct of a defendant that occurred in Delaware or had a substantial effect in Delaware such that it would make one subject to personal jurisdiction in Delaware, that activity may be attributed to another defendant who would not otherwise be amenable to jurisdiction in Delaware if that defendant is a co-conspirator. The court also noted the general rule that a corporation cannot conspire with itself any more than a private individual can. Although the acts of the agent are generally considered to be the acts of the corporation, there is an exception to this rule when an agent acts pursuant to personal motives instead of in his role as an agent of the corporation. Generally, agents of a corporation are not subject to civil liability for conspiring among themselves and with their own corporation. In this case, the plaintiffs did not satisfy the basic elements of a civil conspiracy.

LONG-ARM STATUTE

The court discussed Section 3104(c)(2) of Title 10 of the Delaware Code relating to contracting to supply services or things in Delaware. This basis was not sufficient to establish jurisdiction because a business relationship between an out-of-state defendant’s employer and a company located in Delaware does not provide the necessary contacts to satisfy the Delaware long-arm statute. Next, Section 3014(c)(4) relating to an injury and act or omission outside of Delaware was not helpful to the plaintiffs. That section applies when a defendant has had contacts with Delaware that are so extensive and continuing that it is fair and consistent with state policy to require that the defendant appear here and defend a claim even when that claim arose outside of this state and causes injury outside of this state. Plaintiffs cited to no case law or other authority to support their argument that a receipt by an employee of a salary based on services rendered to a company that derives substantial revenue from its activities in Delaware, is a sufficient basis to confer personal jurisdiction over the defendant.

Finally, the court found that plaintiff failed to satisfy Section 3104(c)(3), which requires a plaintiff to demonstrate that the nonresident defendant caused a tortious injury in Delaware and that such injury was due to an act or omission by the defendant in Delaware.

DUE PROCESS

The court did not reach this analysis, which must be satisfied in addition to the statutory analysis, because the court concluded that there was no statutory basis on which to assert personal jurisdiction. Nonetheless the court provided a hypothetical analysis for why the Due Process Clause would not be satisfied even if there were a statutory basis for jurisdiction.

JURISDICTIONAL DISCOVERY

The court denied the request for jurisdictional discovery for several reasons. First, discovery was never stayed and the court noted that for over two months the plaintiffs had the opportunity to conduct discovery, but they did not do so. In addition, the court determined that the facts on which the jurisdictional issues were based were not in dispute.

The court also conducted a very extensive presuit demand analysis, which the space allotted for this overview did not allow us to cover, but which provides the latest Delaware jurisprudence on the distinction between direct and derivative claims, as well as the procedural presuit demand futility prerequisite for pursuing derivative claims.

We previously noted here the appointment by the Governor of (the former) Master in Chancery Sam Glasscock to be a Vice Chancellor on the Court of Chancery. Now that former Vice Chancellor Strine was recently elevated to the position of Chancellor, the Delaware Senate today approved the appointment of Delaware’s newest Vice Chancellor. Congratulations to Vice Chancellor Glasscock and best wishes for many years of service on the bench.

In my latest ethics column for The Bencher, the national publication for the American Inns of Court, I highlight here a recent unpublished decision of the U.S. Court of Appeals for the Fifth Circuit that reversed a decision of a trial judge imposing penalties on lawyers admitted pro hac vice, as well as others, for allegedly impugning the trial judge’s character. The appellate court also required that another judge hear the case on remand.

A special feature of the article is a link to a compilation prepared by the former chief counsel for the Office of Disciplinary Counsel, an arm of the Delaware Supreme Court, of decisions and private ethics rulings in Delaware regarding standards for lawyers admitted pro hac vice. That compilation is available here.

On the latest episode of the LexisNexis Corporate & Commercial Insights, Steve Berstler speaks to Francis G.X. Pileggi, Member-in-Charge, Eckert Seamans Cherin & Mellott, LLC, Wilmington, DE, about the impact of the recent Delaware Court of Chancery’s Goggin decision on annual shareholder meetings as well as fairness issues in In Re Cencom, and the confirmation of Chancellor Leo Strine, Jr. The videocast is available here.

The Delaware Supreme Court decided an issue of first impression this month in a ruling that exemplified the symbol for justice (at left), blindfolded (indicating impartiality) and holding level scales (for fairness).

In Sullivan v. Elsmere, No. 467, 2010(Del. Supr. June 17, 2011), Delaware’s High Court, sitting en banc, ruled that when one member of a seven-member panel demonstrates a prima facie bias, even a unanimous vote by that panel violates due process if the panel acts without removing the tainted member of the panel.

Although the panel in this matter was formed by the Town Council and Mayor of a small town in Delaware, and their decision involved the termination of the police chief, the principles espoused in the Court’s opinion are a celebration of fundamental concepts on which our country is based, and have at least theoretical relevance in a broader context to group dynamics and the toxic influence on a group when even one person among many is less than impartial.

Brief Factual Context

The factual background of this case involved one member of the panel who, prior to the vote, had threatened the police chief and told him, in essence, that he was “… finished in this town” because the chief had not hired a boyfriend of the panel member’s daughter.

Issue

Whether one allegedly partial member of a multi-member tribunal taints the entire tribunal’s decision and deprives a party of due process even when the tribunal’s decision is unanimous.

Analysis

Even if the panel member were not biased in fact, the  Court explained that the evidence presented the appearance of bias, and the Court reasoned that: “… the appearance of bias [was] sufficient to cause doubt about [the tainted panel member’s] impartiality because an objective observer viewing the circumstances would conclude that [the tainted panel member] could not or would not participate fairly or impartially in [the police chief’s] hearing”.

Requirement of Fundamental Fairness

It is well-settled that a “fair trial is a basic requirement of due process” and this fundamental concept “applies to administrative agencies as well as courts”. Although the requirement in Delaware’s Constitution of a unanimous jury in criminal proceedings was noted by comparison, the Court was aware that in this case a unanimous vote of the panel was not required (even though the dismissal of the police chief was unanimous on the points that were sufficient to dismiss him.)

The Chief Justice, writing for the full court, referred to many other courts that have addressed the issue and found that “the prevailing perspective is that the bias of one member of a multi-member adjudicatory tribunal taints the entire tribunal’s decision and deprives the party subject to the tribunal’s judgment of due process.” The opinion went on to discuss the group dynamics of decisionmaking and the impact that one person can have on the group. Also, while reversing and remanding the case for a new hearing, the Court was aware of the lack of predictability that the result of a new hearing would be different.

Cross-Appeal Procedural Issue

Another important aspect of the opinion was a procedurally important part of appellate practice called “cross-appeals”. Anyone involved in an appeal to the Delaware Supreme Court should read the section of the opinion accompanying footnotes 8 to 18. In sum, if one wants to argue any “adjustments” to any aspect of the lower court’s decision, a cross-appeal is the safe route. The opinion quoted from a U.S. Supreme Court decision that described the “cross-appeal rule”, in part, as:

“… that unwritten but longstanding rule, [pursuant to which] an appellate court may not alter a judgment to benefit a nonappealing party…. It takes a cross-appeal to justify a remedy in favor of an appellee.”

The Legal Ethics Forum links here to a post on the Volokh blog here about weak and politically charged legal ethics issues raised as a means of attack against conservative U.S. Supreme Court justices by those on the left who disagree with the decisions of the so-called conservative majority of our nation’s High Court. Legal ethics can easily be misused and abused as a sword to attack or undermine those who cannot be attacked on the substance of their arguments, or on any other meritorious basis. This is so because the flimsiest assertion of a legal ethics claim can be made by anyone, however uninformed; it takes little or no effort to make the allegation, but it requires substantial effort by the accused to clear her name. Compare the reluctance of Delaware courts to allow motions to disqualify counsel due to alleged conflicts of interest to derail a lawsuit, as indicated in a decision highlighted on these pages  here.

Anyone can lodge a “claim” against a lawyer or judge on alleged legal ethics, but the assertion alone does not ipso facto make it so. Those persons within the profession vested with the responsibility to filter the frivolous claims from the credible ones have an unenviable but important job. Everyone interested in the stability of the legal profession should be concerned when legal ethics are used as a cheap and inappropriate method to advance political goals.

Delaware Chief Justice Myron Steele recently spoke at the Stanford Law School Directors’ College about the interface between federal jurisdiction over corporate governance issues and the traditional province of state law, such as Delaware’s, in that arena. Here are a few highlights of His Honor’s remarks from Kevin LaCroix on his award-winning blog called The D & O Diary.

The opinion by the Delaware Court of Chancery in this case addresses the impact, if any, on the rights of limited partners based on the use of the word “fair” in a disclosure statement that described the winding-up process pursuant to the terms of a limited partnership agreement. In Re Cencom Cable Income Partners, L.P. Litigation, Cons. C.A. 14634-VCN (Del. Ch., revised June 6, 2011), read opinion here. The introduction to the opinion has the distinction of including one of my all-time-favorite “opening lines” to any opinion, from any court, at least in part due to its recognition of a quotidian reality–a recognition that is usually lacking in the legal profession, on both sides of the bench. The Court’s 33-page opinion begins as follows:

We all have bad days. The unknown drafter of a disclosure statement explaining to limited partners the process for winding up a partnership had one of those days. A limited partnership, in accordance with the terms of its governing document, was coming to an end. A process had been prescribed for establishing the sale price of its assets. A law firm was retained to assure that the limited partners’ rights under the limited partnership agreement would be protected. The drafter of the disclosure statement, for reasons that will never be known, wrote that the law firm was engaged to assure the limited partners that the dissolution process would be “fair”. The Plaintiffs have latched on to that phrase and argue, in essence, that the use of the word “fair” imbues their challenge with all of the prinicples of “entire fairness” as that concept has evolved in our jurispridence. Ultimately, that is an untenable stretch: the substantive rights of the limited partners are determined by reference to the provisions of the limited partnership agreement, and one sentence in a disclosure document cannot change those rights. Perhaps more importantly, no reasonable limited partner would have read that sentence and accepted that her rights would be amplified in such a fashion.

Issues:

Among the issues addressed were:

1) Was a duty to assure the fairness of the sale process both assumed and breached, as described by a disclosure statement regarding the process for the sale of the assets during the winding up period?

2) Were fiduciary duties breached by the manner in which the appraisal and sale were conducted?

The Court also addressed the related issues of: (i) whether the general partner manipulated to its benefit the process by which the partnership assets were valued and sold, and (ii) whether approval by the limited partners of the sales process which established a price and provided for interest on that amount following a date certain until distribution of the sales proceeds acted to deprive the limited partners of the right to any quarterly distributions following the start of the period during which interest would be paid.

This case is hoary by Chancery standards and was filed in 2005. A prior Chancery decision in this matter from 2008 that provides more background was highlighted on these pages here.

Analysis

The Court acknowledged that in “assessing the sufficiency of a disclosure, a court must examine the ‘total mix’ of information made available to the, in this instance, limited partners.” The opinion explained why the plaintiffs placed too much emphasis on the word “fair” in the disclosure statement, and reasoned that upon a “reasonable reading of the words chosen to describe Husch’s  [the law firm that prepared the document] role, it becomes apparent that a reasonable Limited Partner would have understood that Husch had undertaken a effort to assure that the Limited Partners received that which they contracted for through the Partnership Agreement.”

The opinion continues by reasoning that: “Moreover, how a “fairness notion would, or should ever, be imposed upon a express contractual relationship, evidenced by a Partnership Agreement, is unclear…. The mere use of the word ‘fair’, however, does not implicate those principles [of  ‘entire fairness’ from Delaware corporate jurisprudence] to override the terms of the contractual relationship, at least, where there is nothing inherently or fundamentally ‘unfair’ about the transaction.”

Appraisal Procedure Followed Agreement and Industry Standards Notwithstanding the misplaced emphasis on the use of the word “fair” by the plaintiffs, the Court reviewed the procedures followed in the sale process and the preparation of the appraisals, and found the process used to be consistent with the Partnership Agreement, and the efforts made to be both reasonable and fair.

The methods used by the appraisers followed the guidelines in the Partnership Agreement and  also followed “standard appraisal techniques”, using income and market methodologies. The Court noted at footnote 60 that simply because the appraisers reached different valuation conclusions does not mean that they used non-standard appraisal techniques. See also footnotes 75 and 76 (regarding whether business units should have been valued individually or in the aggregate.)

Conclusion

In sum, the Court found that the appraisal and the sale process did not deny the Limited Partners the benefit of their bargain as described in the Partnership Agreement. In addition to being a fair process, to the extent that there may have been a deviation from the procedures in the agreement, the Limited Partners were not damaged.

The Delaware Senate today confirmed the governor’s appointment of Leo Strine, Jr. as the new Chancellor of the Delaware Court of Chancery, reports Tom Hals of Reuters. Strine has been a vice chancellor on the court for more than 12 years, and thus, the transition is expected to be seamless. As previously noted on these pages, the current Master in Chancery, Sam Glasscock, was appointed recently by the governor to fill Strine’s old seat on the bench, and is expected to be confirmed imminently as the court’s newest vice chancellor.

Paige Cap. Mgmt., LLC v. Lerner Master Fund, LLC, C.A. No. 5502-VCS (Del. Ch. May 5, 2011), read opinion here.  In this decision the Court of Chancery discussed the application of the absolute litigation privilege (e.g., for defamatory statements made in connection with a lawsuit), and Delaware Rule of Evidence 408, to a pre-litigation threat made during settlement discussions. We previously provided a link here to a video/audio clip of prior proceedings in this case.

The underlying cause of action in Paige is a contract dispute, but the issue in this decision concerns the admissibility of evidence at trial.  The plaintiffs, an amalgam of individuals, companies and investment funds that operates a hedge fund, and the defendants, the primary investors in the hedge fund, disagree as to the admissibility of an email wherein one of the plaintiffs threatened “to breach its fiduciary duties” (as candy-coated by the Court) if the defendants did not surrender to the plaintiffs’ settlement demands. 

The Absolute Litigation Privilege

The Court provided the following summary of the absolute litigation privilege:

A traditional privilege has attached to testimony in judicial proceedings that immunizes a lawyer or witness from a collateral claim alleging that the testimony amounted to defamation or a related tort based on the alleged reputational harm suffered by a third party because of what the lawyer or witness said.  That privilege has been deemed absolute and is thought to serve several important purposes, including encouraging the peaceable resolution of disputes in the courts, fostering the willingness of witnesses to testify freely and counsel to argue zealously, and limited the proliferation of follow-on lawsuits.

 This privilege has long been recognized in Delaware.  In practice, it protects lawyers and witnesses from potential defamation liability where a defamatory statement (1) was made as part of a judicial proceeding and (2) was relevant to the matter at issue.

The first question was whether the email threat in this case was made as part of a judicial proceedings.  Prior to Paige, the Delaware Superior Court accepted (in dicta) that the absolute litigation privilege applied to pre-litigation communications. In this decision, the Chancery Court assumed (without holding) that the Superior Court’s dicta expanded the privilege to statements made outside of judicial proceedings.  The plaintiffs, however, sought to further expand the coverage of the privilege from defamation and related torts arising from derogatory statements alleged to be harmful to the suing party’s reputation or psychic well-being,” to all tort actions.  Believing that part of the utility of and the public policy rationale behind the privilege would be lost by such an expansion, the Court did not adopt the plaintiffs’ position. 

Additionally, the Court found that other jurisdictions that expanded the privilege did so to “allow[] parties to peaceably resolve disputes in advance of litigation by previewing claims that will be made in good faith litigation,” rather than “immunize statements about future wrongful actions a speaker will take if the recipient does not meet the speaker’s settlement demand,” as the plaintiffs seek here.  The Court stated that “embracing the idea that the law immunizes threats of future wrongful action simply because they were connected to an offer to settle a lawsuit” would vitiate the purpose of the privilege.

Further, expanding the absolute litigation privilege would render Delaware Rule of Evidence 408 (and its Federal Rule counterpart), which bars the admissibility of certain settlement discussions from evidence,  largely “superfluous.”  The threatening email was definitely an offer of settlement as defined by the Rules of Evidence; however, Rule 408 cannot be used to prevent a plaintiff from proving his case, or shield wrongful acts because they took place during settlement negotiations.  Federal courts have applied this principle to threats made by parties during settlement negotiations and found that “such threats fall outside the scope of Rule 408.” 

Additionally, the Court clarified that Rule 408 does not bar the admissibility of evidence of a new wrongdoing or a future wrongful state of mind, as compared to the wrongdoing that led to the initial litigation and the need for settlement discussions.

The Court concluded that the threatening email was not protected by the absolute litigation privilege and its admission as evidence at trial was not barred by Rule 408.