Chancery Interprets Confusing LLC Agreement

A recent Delaware Court of Chancery decision interpreted an ambiguous LLC agreement that it described–at least “at first read”–as “confusing and internally inconsistent.” The decision in MKE Holdings Ltd. v. Schwartz, C.A. No. 2018-0729-SG (Del. Ch. Sept. 26, 2019), in addition to being a helpful analysis for purposes of providing an insight into how the court analyzes an agreement that is not self-explanatory, will remain noteworthy because its introductory paragraph should be required reading for any lawyer who drafts an LLC operating agreement.  The introduction to the referenced opinion provides as follows:

“This matter requires me to construe an LLC operating agreement. My father was an engineer.  He frequently remarked that machinery would not be so poorly designed if the designer were condemned personally to keep it operating.  I am a lawyer.  I am struck that LLC agreements would be better drafted if the drafters were compelled to litigate over them, or worse, construe them as judges.  In any event, such is the task I must undertake here.” (footnotes omitted.)

Chancery Explains Step-Transaction Doctrine and Defines “Affiliate

A recent Delaware Court of Chancery opinion is noteworthy for its discussion of many aspects of the law, but I intend to highlight only a few of them, including its description of the important concept known as the Step –Transaction Doctrine. In PWP XERION Holdings III LLC v. Redleaf Resources, Inc., C.A. No. 2017-0235-JTL (Del. Ch. Oct. 23, 2019), the court engaged in a thorough analysis of the issues related to the failure of a company to obtain prior written consent from a major stockholder before approving certain transactions.

Key Takeaways from this Decision

Step-Transaction Doctrine:

The doctrine “treats the steps in a series of formally separate but related transactions involving the transfer of property as a single transaction if all the steps are substantially linked. Rather than viewing each step as an isolated incident, the steps are viewed together as components of an overall plan.” See pages 31-32.

The court explained that the step-transaction doctrine applies if the component transactions meet one of three tests. First, the “end result test” will allow the doctrine to be invoked if it appears that a series of separate transactions were pre-arranged parts of what was a single transaction, cast from the outset to achieve the ultimate result. Id.

Second, under the interdependence test, separate transactions will be treated as one if the steps are so interdependent that the legal relations created by one transaction would have been fruitless without a completion of the series. The third and most restrictive test is the binding-commitment test under which a series of transactions are combined only if, at the time the first step is entered into, there is a binding commitment to undertake later steps. Id.

Analysis of the Terms “Affiliate” and “Business Plan.”

The court analyzed the term affiliate as it applied to a company director because consent was required for certain transactions with an affiliate of a director. See pages 17 to 21.

The court also analyzed the meaning of “business plan” because prior consent of a major stockholder was required before any changes could be made to the business plan. See pages 22 to 25.

Other Useful Statements of Delaware Principles of Law Regarding Tension between Board’s Fiduciary and Contractual Duties:

The court also discussed the concept that a board can fulfill its fiduciary duties while making a decision that (complying with those fiduciary duties) might call for engaging in “an efficient breach” of contract. See page 34.  Contrariwise, a board could comply with a contract which would result in a breach of fiduciary duty. Id.

The court also explained, in connection with a stockholder and its board-designee who took different positions on the same issue: that the rights of a stockholder, and what a stockholder might lawfully be permitted to do, are much different than the duties of a director-designee of that stockholder.  The court explained that a stockholder and its director designee occupied:

(i) different roles;

(ii) are subject to different decisional frameworks; and

(iii) can legitimately have different views.

Other cases on these pages have addressed the duties of a “blockholder director”  who must act in the best interests of all stockholders–and not only the stockholder who appointed the director.

Chancery Provides Guidance on Electronic Discovery Practices

A recent Delaware Court of Chancery decision is noteworthy for the clarification it provides regarding several nuances of electronic discovery practice. See Ferguson v. Capital Development Insurance Company, LLC, C.A. No. 2018-0831-KSJM (Del. Ch. Oct. 8, 2019).

Key Points: Among the helpful takeaways from this short letter ruling are the following:

  • Although the Guidelines for Practitioners in the Delaware Court of Chancery suggest that the proponent of discovery should propose protocols for the recipient to use in the collection and production of ESI, the court explained that the protocol does not constitute a formal rule of court, and therefore, cannot be “weaponized” as a basis to refuse to reply to discovery requests.
  • The court observed that sometimes the person receiving discovery requests is best suited to propose ESI protocols for search, collection and production–given their superior knowledge of their data repositories, but this is not a requirement that has the force of a rule.
  • The court instructed, however, that it “encourages the proponent of discovery to propose protocols that the recipient may use when collecting electronically stored information.”

Pro Se Representation of Corporations Prohibited: In a statement of law not related to electronic discovery, the court reiterated the truism that in Delaware, entities may not appear pro se, but rather they must be represented by counsel before the court (even when it is a wholly-owned company). See Harris v. RHH P’rs, LP, 2009 WL 891810, at *2 (Del. Ch. Apr. 3, 2009).

Chancery Grants Advancement, Rejects Common Defense

For those readers who follow the many Chancery decisions highlighted on these pages regarding advancement for corporate officers and directors, the recent Court of Chancery decision in Nielsen v. EBTH Inc., C.A. No. 2019-0164-MTZ (Del. Ch. Sept. 30, 2019), can be added to the long line of cases that reject an argument that the requirement for advancement–that the underlying litigation was brought “by reason of the fact” of the claimant’s role as a director or officer–was not satisfied. As the court described it: “Few cases present facts that fall short of Delaware’s standard favoring advancement. This case follows the common pattern.”

An article co-authored by the undersigned, and Chauna Abner, provides a more complete overview of this case and appeared in The Delaware Business Court Insider.

Directors may face oversight liability for not properly monitoring key drug’s clinical trial

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

The business judgment rule cannot shield Clovis Oncology Inc.’s directors from shareholder charges that they breached their oversight duty by ignoring reports that their flagship cancer-fighting drug was unlikely to pass regulatory tests, the Delaware Chancery Court has ruled in the matter styled: In re Clovis Oncology Inc. Derivative Litigation, No. 2017-0222-JRS, memorandum opinion (Del. Ch. October 1, 2019).

Vice Chancellor Joseph R. Slights’ Oct. 1 opinion allows the biopharmaceutical startup’s investors to proceed with derivative claims that Clovis lost $1 billion in value after the market learned that its directors failed to comply with regulatory protocol for Rociletinib.

He said duty-of-oversight charges have been among the hardest to prove, but the Clovis plaintiffs well-pled that their directors did not respond to red flags at a time when the company’s fate. depended largely on the outcome of a single lung cancer therapy trial.

A duty-of-care duo

The Clovis opinion, and the Delaware Supreme Court’s June decision in Marchland v. Barnhill, 212 A.3d 805 (Del. 2019), are being closely examined by corporate law specialists because together they provide a new avenue to sue for violating the duty of oversight.

In June, the Delaware Justices reversed a Chancery Court dismissal of a consolidated shareholder suit that charged the Blue Bell Creameries directors’ failure to oversee ice cream safety resulted in a deadly and costly listeria outbreak in 2015. The opinion, written by Chief Justice Leo E. Strine Jr., found the Blue Bell board “made no effort to put in place a board-level compliance system.”

That, he said, was a violation of the first part of the oversight duty spelled out in the seminal 1996 Caremark decision which said directors must set up and monitor systems to ensure that they get adequate information on whether the company is being operated properly. In re Caremark Int’l. Inc. Deriv. Litig. 698 A. 2d 959 (Del Ch. 1996).

Caremark duty, part two

Vice Chancellor Slights’ Clovis opinion was based on Marchand decision and focused on the second part of the Caremark duty: to properly monitor the systems the directors set up,

The plaintiffs claimed the Clovis directors in fact paid very little attention to the plan and protocol they set up for the clinical trial of Roci, an initially promising lung cancer treatment. In later stages though, there were ample indications that Roci would not get the U.S. Food & Drug Administration’s approval for market, Vice Chancellor Slights said.

The consolidated suit charged Clovis executives entered ineligible information in the clinical trial’s records that “allowed the company to mislead the market regarding the drug’s efficacy.”

The plaintiffs said when Clovis was later forced to enter the correct information, it was clear that Roci would not be approved, but some directors and a senior executive sold stock before the market learned the bad news.

In response to the defendants’ motion to dismiss, the vice chancellor said the duty to implement a proper oversight system and then monitor it is important, “especially so when a monoline company operates in a highly regulated industry.”

He noted that at the beginning of the clinical trial Clovis had no other drugs on the market, received no sales revenue and was entirely dependent on investor capital.

Business risk vs. oversight risk

Directors must have great latitude in making decisions on business risk, but “it is appropriate to distinguish the board’s oversight of the company’s management of business risk” from the board’s oversight of compliance with regulatory mandates, the judge said.

In refusing to dismiss the breach-of-duty charge he said he was satisfied that plaintiffs have properly pled that the directors “consciously ignored red flags that revealed a mission critical failure to comply” with the protocol and FDA regulations.

However, Vice Chancellor Slights dismissed an insider selling charge for lack of proof of scienter, finding that it is not enough that the sale took place near the time that the insider acquired non-public information.

This is especially true where the size of the trade is not abnormally large and does not represent a dramatic change in trading pattern, he said.

Based on the same findings, the Court also dismissed a charge that some defendants improperly enriched themselves from the insider selling.

Takeaways

Vice Chancellor Slights’ detailed recitation of what he found to be the Clovis directors’ failures to monitor and disclose Roci’s true test history could serve as a cautionary tale for a new, stricter Caremark era.

Or, turned around, it could provide proactive directors and their counsel with a to-do list for revising board-level control and disclosure.

Termination Fee May Not be Sole Remedy for Termination of Merger Agreement

A recent Delaware Court of Chancery opinion allowed a claim to proceed based on the theory that a termination fee for a merger agreement was not the sole remedy for breach of contract.  In Genuine Parts Co. v. Essendant, Inc., C.A. No. 2018-0730-JRS (Del. Ch. Sept. 9, 2019), the court discussed a very fact-specific, contract-based reason why the termination fee was not the sole remedy for a potentially willful breach of the merger agreement.

Key Facts:

The non-solicitation provision in the merger agreement had a “fiduciary-out” which was subject to various parameters and notice requirements.  There was also a “willful breach” exception to the termination fee as a sole remedy. 

In addition, the target-company met with another suitor before signing the merger agreement despite: (i) a representation that there were no other suitors; and (ii) no notice or disclosure of that pre-agreement meeting being made.

The claims included breach of contract because the competing bid that was accepted was allegedly not a superior bid.

Highlights of Court’s Analysis:

The court explained that non-solicitation provisions are routine, and that there is no per se prohibition about a non-solicitation provision as long as there is a “safety valve” that allows for a board to consider a superior offer. See Slip op. at 23-24, and footnotes 76-78.

The court distinguished a prior Chancery decision, which had materially different terms in the applicable agreement, where the court determined that a losing bidder was unlikely to get specific performance beyond the termination fee.  See Cirrus Holding Co. v. Cirrus Industries, Inc., 794 A.2d 1191 (Del. Ch. 2001).

By contrast, the court did follow the reasoning of another Chancery decision that found, based on the terms of the contract in that case, that a termination fee was not an exclusive remedy.  See NACCO Industries, Inc. v. Applica, Inc., 997 A.2d 1 (Del. Ch. 2009).

Delaware State Bar Association Responds to Attack Ads Against Delaware Courts

Recent attack ads appearing on TV that apparently were financed by a disgruntled litigant unhappy with the results of a decision by a Delaware court, generated an unusual response from the Delaware State Bar Association. A website called Town Square Delaware provides a copy of the letter. The Delaware Business Court Insider also published an article about the attack ad, in which they quoted yours truly (condemning the misguided ad.)

Forum Selection Clauses; Delaware Law; Federal Law; Internal Affairs Doctrine; and Chancery’s Sciabacucchi Decision

For readers who follow the law regarding forum selection clauses, a recent article by Professor Joseph Grundfest should be of interest. The good professor addresses the December 2018 Court of Chancery decision in Sciabacucchi v. Salzberg (highlighted on these pages), and the intersection of Delaware law and Federal law in the context of forum selection clauses and the internal affairs doctrine. The abstract follows to his article titled: The Limits of Delaware Corporate Law: Internal Affairs, Federal Forum Provisions, and Sciabacucchi

Abstract

The Securities Act of 1933 provides for concurrent federal and state jurisdiction. Securities Act claims were historically litigated in federal court, but in 2015 plaintiffs began filing far more frequently in state court where dismissals are less common and weaker claims more likely to survive. D&O insurance costs for IPOs have since increased significantly. Today, approximately 75% of defendants in Section 11 claims face state court actions. Federal Forum Provisions [FFPs] respond by providing that, for Delaware-chartered entities, Securities Act claims must be litigated in federal court or in Delaware state court.

In Sciabacucchi, Chancery applies “first principles” to invalidate FFPs primarily on grounds that charter provisions may only regulate internal affairs, and that Securities Act claims are always external. In so concluding, Sciabacucchi adopts a novel definition of internal affairs that is narrower than precedent, and asserts that plaintiffs have a federal right to bring state court Securities Act claims. It describes all Securities Act plaintiffs as purchasers who are not owed fiduciary duties at the time of purchase. The opinion constrains all actions of the Delaware legislature relating to the DGCL to comply with its novel definition of “internal affairs.”

Sciabacucchi’s logic and conclusion are fragile. The opinion conflicts with controlling U.S. and Delaware Supreme Court precedent and relies critically on assumptions of fact that are demonstrably incorrect. It asserts that FFPs are “contrary to the federal regime” because they preclude state court litigation of Securities Act claims. But the U.S. Supreme Court in Rodriguez holds that there is no immutable right to litigate Securities Act claims in state court, and enforces an agreement that precludes state court Securities Act litigation. Sciabacucchi assumes that Securities Act plaintiffs are never existing stockholders to whom fiduciary duties are owed. But SEC filings and the pervasiveness of order splitting conclusively establish that purchasers are commonly existing holders protected by fiduciary duties. The opinion fears hypothetical extraterritorial application of the DGCL. To prevent this result, it invents a novel definition of “internal affairs” that it applies to constrain all of the Legislature’s past and future activity. But the opinion nowhere addresses the large corpus of U.S. and Delaware Supreme Court precedent that already precludes extraterritorial applications of the DGCL. It thus invents novel doctrine that conflicts with established precedent in an effort to solve a problem that is already solved. The opinion’s novel, divergent definition of “internal affairs” also conflicts with U.S. and Delaware Supreme Court precedent that the opinion nowhere considers.

Sciabacucchi is additionally problematic from a policy perspective. By using Delaware law to preclude a federal practice in federal court under a federal statute that is permissible under federal law, Sciabacucchi veers Delaware law sharply into the federal lane and creates unprecedented tension with the federal regime. Its narrow “internal affairs” definition invites sister states to regulate matters traditionally viewed as internal by Delaware, and advances a position inimical to Delaware’s interests. By propounding its divergent internal affairs constraint as a categorical restriction on the General Assembly’s actions, past and future, the opinion causes the judiciary to intrude into the legislature’s lane. And, data indicate that the opinion in Sciabacucchi caused a statistically and economically significant decline in the stock price of recent IPO issuers with FFPs in their organic documents.

In contrast, a straightforward textualist approach would apply the doctrine of consistent usage and use simple dictionary definitions to preclude any extension of the DGCL beyond its traditional bounds. Textualism avoids all of the concerns that inspire the invention of a divergent “internal affairs” definition. Textualism does not require counter-factual assumptions, conflict with U.S. or Delaware Supreme Court precedent, cause Delaware to constrain federal practice in a manner inconsistent with federal law, or advocate policy positions inimical to Delaware’s interest. Textualism also interprets the DGCL in a manner that profoundly constrains the ability of all Delaware corporations to adopt mandatory arbitration of Securities Act claims. Textualism validates FFPs in a manner that precludes the adverse, hypothetical, collateral consequences that animate Sciabacucchi’s fragile analysis, without generating Sciabacucchi’s challenging sequelae.

Keywords: Securities Act, forum selection, Delaware, jurisdiction, litigation, Section 11, charters, by-laws, internal affairs, federal forum provisions

JEL Classification: K22, K41

Suggested Citation
Grundfest, Joseph A., The Limits of Delaware Corporate Law: Internal Affairs, Federal Forum Provisions, and Sciabacucchi (September 12, 2019). Rock Center for Corporate Governance at Stanford University Working Paper No. 241. Available at SSRN: https://ssrn.com/abstract=3448651 or http://dx.doi.org/10.2139/ssrn.3448651
 

Delaware Supreme Court Instructs on Standards of Deposition Conduct

A recent Delaware Supreme Court opinion provides a tutorial on the standards imposed on Delaware lawyers when a deponent, who is the lawyer’s client, engages in inappropriate conduct during a deposition. See Shorenstein Hays-Nederland Theaters LLC Appeals, Nos. 596, 2018 and 620, 2018 (Del. Supr. June 20, 2019). My overview of the decision was the focus of my latest legal ethics column for The Bencher, the publication of the American Inns of Court, which appears in the current issue. (I’m now in my 21st year of writing that ethics column for their national publication.)

This is the first decision from Delaware’s High Court on this issue, as compared to the rather abundant guidance that has existed for many years regarding the consequences when lawyers themselves engage in errant conduct during a deposition. A prior Chancery decision from 2015 involving the parties in this case was highlighted on these pages, and provides additional factual background details about the underlying long-running, internecine imbroglio that the court was ruling on–before it addressed the deposition issues.

Bonus Supplemental Materials:

Chancery Describes Special Litigation Committee Requirements for Alternative Entities

The requirements for a special litigation committee, in the alternative entity context, that seeks recognition of its legitimacy from the court was recently explained in the Delaware Court of Chancery decision styled: Wenske v. Blue Bell Creameries, Inc., C.A. No. 2017-0699-JRS (Del. Ch. Aug. 28, 2019).

Short Overview of Case:

This case involves a derivative action arising from the alleged failures of Blue Bell Creameries, Inc. (“BBGP”) as the sole general partner of the nominal defendant, Blue Bell Creameries LP (“Blue Bell” or the “Partnership”), to operate the Partnership in compliance with the governing standards of the limited partnership agreement (“LPA”). The court previously denied the motion to dismiss based on a finding that the plaintiff adequately pled demand futility. See Wenske v. Blue Bell Creameries, Inc., 2018 WL 3337531, at * 19 (Del. Ch. July 6, 2018), reargument denied, 2018 WL 5994971 (Del. Ch. Nov. 13, 2018).  After the denial of the motion to dismiss, BBGP created a committee of its board of directors that, in turn, formed a special litigation committee to manage the claims against BBGP.  As often happens, the special litigation committee moved to stay the derivative action to allow it time to conduct an investigation and make a determination.  The court observed that when properly made, such requests are often granted.  But, the court found that such a request in this case was “not proper.”

Highlights of Court’s Reasoning:

The court explained that in the context of this limited partnership structure, the sole general partner had already been determined to have a “disabling interest for pre-suit demand purposes.” Id. at * 18.

The court explained that “as a matter of agency law, a principal who delegates authority to an agent” will be deemed to maintain control over the conduct of that agent–regardless of whether the principal actually exercises control. Any conflict that disables the principal disables the agent.

Based on its prior ruling that BBGP, as principal, is not fit to decide how to manage the claims against the defendants, including against BBGP itself, the special litigation committee, as agent, is likewise disabled. Thus, the motion to stay was denied because it was brought by a special litigation committee with “no authority to bring it.”  Slip op. at 2.

Important Legal Principles Recited by the Court:

This opinion is noteworthy for the many important statements of law it recites regarding the prerequisites for a properly functioning special litigation committee, not only in the corporate context, but–more importantly–in the less often addressed alternative entity context which does not enjoy as robust a body of case law compared to the corporate context on this issue.

The following bullet points provide a sample of the more notable legal nuggets:

  • The court observed the important function that special litigation committees serve to respond to accusations of series misconduct by high officials and an impartial group of independent directors. (citing Biondi v. Scrushy, 820 A.2d 1148, 1156 (Del. Ch. 2003), aff’d, 847 A.2d 1121 (Del. 2004)).
  • The court instructed that: “A well-functioning, well-advised special litigation committee, whose fairness and objectivity cannot reasonably be questioned, can serve to assuage concern among stockholders that the company’s litigation assets are being managed properly.” (internal citations omitted) (citing Id., and Zapata Corp. v. Maldonado, 430 A.2d 779, 787 (Del. 1981)).
  • The court noted that in the Biondi case, the court denied a motion to stay because the special committee was demonstrably not independent. See footnote 13.
  • The court emphasized that a threshold issue is whether the committee was properly constituted.
  • The court cited the seminal Zapata v. Maldonado case as involving a conflicted corporate board that wrested control of a derivative claim from a stockholder by establishing a committee of independent directors to investigate the claim and determine whether to prosecute it.
  • Although the court noted that Section 141(c) allows a board to delegate all of its authority to a committee, for purposes of this case and based on a prior ruling in this case, the contrast with the context of an alternative entity was underscored by the following rationale:  “. . . the delegation of management authority by a conflicted board to an independent committee of the board, is the delegation of authority by a conflicted group of principal decision makers to a subset of unconflicted principal decision makers. There is no principle/agent relationship created in this [corporate] context.”
  • Although the Zapata special litigation committee framework may, as a general matter, serve its intended purpose in the partnership context, in this case the problem was that the court already determined that the sole general partner of the L.P. had a disabling conflict. See generally 6 Del. C. §§ 17-1011-103, and 17-403(c) (regarding the authority to determine whether to prosecute derivative actions, and unless otherwise restricted in the partnership agreement, a general partner has the power to delegate various rights).
  • But the court reasoned that: “. . . just as the special litigation committee of a corporate board must be independent to be effective under Zapata, so too must a special litigation committee of a general partner of a limited partnership be independent if it is to perform its mandate properly and with binding effect.See footnote 22.
  • The problem in this case for the committee was that in the limited partnership context, the court “does not draw a distinction between a general partner and the members of its board of directors when assessing conflicts.”
  • The court advised that a sole general partner cannot cleanse its disability by appointing new members to its board of directors, or by contracting out its authority to manage the litigation asset to third parties, because it no longer has that authority.
  • The precise issue that the court had to resolve in this case was whether BBGP, as the exclusive general partner of the limited partnership, after already having been deemed unfit to consider a litigation demand, could avail itself of the Zapata framework by establishing a special litigation committee comprised of non-general partner actors. The Court’s answer: No.
  • After distinguishing the facts in the case of Katell v. Morgan Stanley Gp., Inc. (Katell II), 1993 WL 205033, at * 2 (Del. Ch. June 8, 1993), the court reasoned that the problem for BBGP, unlike the limited partnership structure in the Katell case, was that the limited partnership in this case had no other general partner that was not conflicted. Cf. Obeid v. Hogan, 2016 WL 3356851, at * 11 (Del. Ch. June 10, 2016) (The fact that demand was excused or futile did not strip the board of its corporate power. Rather, the problem is one of member disqualification, not the absence of power in the board–in the corporate context.)
  • The court compared the analogy in the corporate context of a sole conflicted director who would be disabled from serving or creating a special litigation committee. See Zapata, 43 A.2d 787.
  • In the instant case, a defining feature of the principal-agent relationship is the principal’s inherent control over the conduct of the agent, and it is the existence of the right to control, not its exercise, which is decisive. Slip op. at 12-13.
  • Although in the corporate context the effort by BBGP in this case to appoint independent members may have been effective, because the lone general partner, as an entity, in this case has been determined to be conflicted, “there is no non-conflicted principal decision maker who can properly delegate management authority” to a special litigation committee.
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