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In an article for the current issue of the Delaware Business Court Insider, I discussed a recent opinion by the Delaware Court of Chancery that denied a motion to dismiss claims against the seller of a business. Those claims included allegations of fraud and breach of fiduciary duty. The article appears below.

The Delaware Court of Chancery recently allowed claims involving breach of fiduciary duty and fraud against the sellers of a business to survive a motion to dismiss. The business provided non-legal administrative services to law firms and their mortgage lender clients in connection with mortgage foreclosures in a number of Western and Midwestern states. The organizational structure of the businesses was relatively complex and involved overlapping entities. The causes of action were seven in number and the court described the multiple motions to dismiss by the defendants as including a “somewhat dizzying array of arguments and counter-arguments.”

The 61-page opinion in CMS Investment Holdings LLC v. Castle, C.A. No. 9468-VCP (Del. Ch. June 23, 2015), provides an extensive description of the facts. In essence, the claims for breach of the LLC agreement, breach of the implied covenant of good faith and fair dealing, unjust enrichment, breach of fiduciary duty, fraudulent transfer and related claims were based on an alleged scheme to deprive the purchaser of receiving the benefit of its bargain. In particular, the LLC that was created to receive the fees generated for administrative services was not being utilized in the manner intended by the parties. For example, instead of the fees being paid to the LLC, the defendants retained the fees for themselves, leading to the LLC’s default on its debt obligations. Moreover, instead of helping the LLC to restructure, the defendants allegedly ushered it into insolvency and then bought the most valuable assets of the company from the LLC’s receivership, the opinion said.

Several important legal principles and analyses with wide practical application are discussed in this opinion. For example, the court discusses the criteria to determine when a claim should be considered direct or derivative. The court explained that the following questions inform the determination: (1) who suffered the alleged harm (the corporation or the suing stockholders individually); and (2) who would receive the benefit of any recovery or other remedy (the corporation or the stockholders individually). However, courts have long recognized that the same set of facts can give rise to both a direct claim and a derivative claim. In this case, the court found that the claims were at least dual claims that have both direct and derivative aspects, and thus were allowed to proceed on that basis.

The court described the types of fiduciary duty claims that could be derivative in nature and also noted several types of direct claims for infringement of a stockholder’s right that are direct in nature, such as an infringement of the right to vote and the right to enforce contractual restraints on the authority of a board pursuant to the charter, bylaws or provisions of the Delaware General Corporation Law. Compare NAF Holdings LLC v. Li & Fung (Trading) Ltd., 2015 Del. LEXIS 310 (June 24, 2015), a recent Delaware Supreme Court decision that held individual contractual rights are direct and not derivative even if a corporation might be a beneficiary of that contract.

The Chancery opinion in CMS includes a helpful articulation of the implied covenant of good faith and fair dealing, and an explanation of why and how, based on the facts of this case, that claim survived a motion to dismiss. The court emphasized the temporal focus as being critical in the analysis of such a claim. Thus, the court addressed what the parties would have agreed to themselves had they considered the issue in their original bargaining positions at the time of contracting.

The court provided a useful description of an unjust enrichment or quasi-contract claim juxtaposed with a breach of contract claim, and explained how those two claims can be pleaded in the alternative in the same complaint. Based on the facts of this case, the court reasoned that the unjust enrichment claim would proceed in the alternative.

Likewise, the court explained how a breach of a contractually-defined fiduciary duty claim can be pleaded compared to a conventional breach of contract claim. The court emphasized that a cause of action for aiding and abetting can only survive in connection with the former claim.

The court explained that the terms of the LLC agreement in this case did not eliminate all the fiduciary duties that could be eliminated under the LLC Act. The court observed that for those fiduciary duties that were not waived by the LLC agreement, there was a factual issue regarding whether the managerial responsibilities of certain of the individual defendants rose to the level that would impose upon them the default fiduciary duties provided for in the LLC Act.

In allowing a breach of fiduciary duty claim to proceed, and to survive a motion to dismiss, the court noted that there may be some situations where simply resigning from the board, without taking other action, may in some circumstances support a claim for breach of fiduciary duty.

In the concluding section, the court addressed a claim pursuant to the Delaware Uniform Fraudulent Transfers Act and allowed the claim for actual and constructive fraud to proceed pursuant to Sections 1304 and 1305 of the act. The court explained that the underpayment or diversion of fees that were properly payable to the LLC supported a claim that those actions were actually, or reasonably appeared to have been, made intentionally to hinder the interests of the plaintiff as a holder of equity and debt in that LLC, for less than reasonably equivalent value, while the LLC was in financial distress.

The court also emphasized that the DUFTA also allows principles of law and equity to supplement its statutory provisions, which formed an additional basis for the court’s refusal to dismiss those claims.

In sum, this opinion efficiently distills complicated facts and a plethora of claims and defenses involving important principles and statements of Delaware law that have widespread applications.

 

 

In Re:  Encore Energy Partners LP Unitholder Litigation, Cons., C.A. No. 6347-VCP (Del. Ch. Aug. 31, 2012).

Issue Presented: Whether the terms of an LP Agreement protected the general partner from claims regarding what would otherwise be a self-interested transaction, without breaching any duty owed to its limited partners?
Short Answer:  Yes.

Background

The Court began its decision by referring to several other relatively recent cases which dealt with the issue of whether the terms of a limited partnership protected the general partners from claims for breaches of fiduciary duty in connection with what would otherwise be self-interested transactions.  See, e.g., In Re K-Sea Transp. P’rs L.P. Unitholders Litig., 2012 WL 1142351 (Del. Ch. Apr. 4, 2012); Gerber v. Enter. Prods. Hldgs., LLC, 2012 WL 34442 (Del. Ch. Jan. 6, 2012); Lonergan v. EPE Hldgs., LLC, 5 A.3d 1008 (Del. Ch. 2010); Brinckerhoff v. Tex. A. Prods. Pipeline Co., LLC, 986 A.2d 370 (Del. Ch. 2010). 

 This case involved a merger that created a potential conflict of interest.  The general partner sought and received “Special Approval” from its conflicts committee before approving a merger that involved an affiliated transaction and submitting it for unitholder approval.  If the “Special Approval” is valid, the Limited Partnership Agreement (LPA) immunizes the merger from judicial challenge and protects the general partner from claims that would otherwise subject it to liability if the economic terms of the merger were shown to be unfair.

Analysis

The Court began with the truism that the Delaware Revised Uniform Limited Partnership Act (“DRULPA”) permits a Limited Partnership Agreement to eliminate all duties, other than the implied contractual covenant of good faith and fair dealing, that a person may owe to a limited partnership and its limited partners.”  The LPA in this case at Section 7.9(e) provided that all duties, including fiduciary duties, would be waived except as expressly set forth in the agreement.  The agreement provided for an express contractual duty of good faith and further provided a “Special Approval” procedure which referred to an approval by a majority of the members of the Conflicts Committee acting in good faith.  Section 7.9(b) defined good faith for purposes of the agreement. 

The Court noted that Vice Chancellor Noble recently “interpreted identical language contained within an LLC Agreement” in the case of In Re: Atlas Energy Resources, LLC, 2010 WL 4273122, at *12 (Del. Ch. Oct. 28, 2010).  In that case, Vice Chancellor Noble concluded based on that agreement that “an act is in good faith if the actor subjectively believes that it is in the best interest of the company, and that to state a claim for breach of the contractually defined fiduciary duty, defendants must have acted in a manner they subjectively believed was not in the best interests of the company and its unitholders.  In other words, the relevant contractual language required a showing that the special committee believed it was acting against the company’s interests.”  See footnotes 53 to 55. 

The Court in this case also referred to a recent Delaware Supreme Court decision in RAA Mgmt., LLC v. Savage Sports Holdgs., Inc., of this year, in which the Court emphasized the importance of the uniform interpretation and application of the same language and contracts.  Thus, the Court in this case interpreted the “identical language of the LPA (that was in the Atlas case), as requiring plaintiffs to allege facts from which one reasonably can infer that the defendants subjectively believed that they were acting against Encore’s interests.”

The Court reasoned that the plaintiffs did not allege sufficient facts from which one could reasonably infer that the Conflicts Committee members subjectively believed they were acting contrary to the interests of the partnership by giving special approval to the merger.

The Court explained that:  “In the final analysis, the relevant inquiry dictated by the LPA was whether the Conflicts Committee approved the merger with the subjective belief that it was in the best interest of the partnership.  Whether their determination was objectively reasonable is not relevant to that contractually prescribed standard.”  See footnote 71. 

Specifically, the Court explained that the plaintiffs did not allege facts from which one could infer the Conflicts Committee made its decision in bad faith:  “i.e., with the subjective belief that their approval was contrary to the partnership’s best interest.”

The Implied Covenant of Good Faith and Fair Dealing

The Court further illuminated its decision by addressing the implied covenant of good faith and fair dealing.  The Court referred to the very recent Chancery decision in ASB Allegiance which dealt with a contract that conferred discretionary rights on a party.  The implied covenant requires such a party to exercise its discretion reasonably.  See also DV Realty Advisors LLC,  another recent case at footnote 78, involving the common law definition of good faith, and highlighted on these pages here.

The Court underscored the following reasoning:  “To use the implied covenant to replicate fiduciary review would vitiate the limited reach of the concept of the implied duty of good faith and fair dealing.  Rather, to state a claim under the implied covenant, plaintiffs must identify how the Conflicts Committee’s allegedly feckless negotiations frustrated the fruits of the bargain that the parties reasonably expected.”  See footnotes 83 and 84.

The Court also concluded that: “The elimination of fiduciary duties implies an agreement that losses should remain where they fall.”  The Court observed that the “near absence under the LPA of any duties whatsoever to Encore’s public equity holders presumably would discourage risk adverse investors that are willing to take a leap of faith from investing their money in an enterprise controlled by the general partner and its affiliates.”  But, the “right to enter into good and bad contracts” makes the implied covenant an ersatz substitute for the warning “caveat emptor.”  The Court advised that:

“Investors apprehensive about the risks inherent in waiving the fiduciary duties of those with whom they entrust their investments may be well advised to avoid master limited partnerships like Encore.  Having decided to take a leap of faith in the reach for the kind of returns the master limited partnership investment might yield, however, plaintiff cannot reintroduce fiduciary review to the back door of the implied covenant.”  See footnotes 96 through 99.

In closing, the Court referred to the recent Gerber and the recent In Re K-Sea cases to support the conclusion that:  “A plaintiff cannot plead that a defendant breached the implied covenant when the defendant is conclusively presumed by the terms of a contract to have acted in good faith.”  See footnote 108.

The Homer C. Gutchess 1998 Irrevocable Trust v. Gutchess Companies, LLC, C.A. No. 4916-VCN (Del. Ch. Feb 16 and 22, 2010), read letter decision here and original transcript of ruling here.

Maura Burke, an associate in our Delaware office, prepared this case summary.

Introduction:  In The Homer C. Gutchess 1998 Irrevocable Trust v. Gutchess Companies, LLC, the Court of Chancery first issued a bench ruling (dated Feb. 16, 2010) and then published a supplemental opinion letter (dated Feb. 22, 2010) dismissing a petition for judicial dissolution of a Delaware limited liability company. Although the limited liability company at issue was created as part of an estate planning program, the Delaware Court of Chancery treated the dissolution of this company as it would with any LLC—by respecting the member’s private preferences as expressed in the company’s operating agreement.

Background: Gutchess Companies, LLC (the “LLC”) was created in 2002 as an estate planning vehicle to hold Homer C. Gutchess’s shares in Gutchess Lumber, a lumber mill and leading supplier of hardwood lumber located in New York state. The operating agreement of the LLC split the voting interest from the equity interest. Homer retained 100% of the voting interest, and 1% of the equity interest. Homer’s wife, Martha, initially held only a 1% equity interest. The remaining 98% equity interest was held by The Homer C. Gutchess 1998 Irrevocable Trust (the “Trust”). Later, Homer transferred his voting interest to Martha, such that Martha held 100% voting interest, and a 1% equity interest in the LLC. After Homer’s death in 2006, Martha appointed Gary Gutchess, her son, as the LLC’s sole manager. Subsequently, a dispute arose between Martha and Gary Gutchess, on the one side, and the trustees of the Trust, on the other. In 2009, the trustees, one of whom is Keith Gutchess, the brother of Homer, petitioned the Delaware Court of Chancery for dissolution of the LLC pursuant to Section 18-802 0f the Delaware Limited Liability Company Act (the “Act”).

In support of their petition for dissolution, the trustees alleged misconduct by the LLC’s management, including accusations that the LLC’s management deliberately generated tax liabilities for the Trust while withholding distributions and/or refusing to generate income that would allow for the payment of those taxes. In response, the LLC moved to dismiss the petition for dissolution on a 12(b)(6) motion for failure to state a claim.

Bench Ruling: Vice Chancellor Noble found that Homer made an informed decision to split the voting and equity interests in the LLC, and “the Court must respect the private ordering of affairs.” (Transcript dated Feb. 16, 2010, at 44-45).

Additionally, V. C. Noble found that the dissolution of the LLC was not an appropriate remedy based upon the Trust’s allegations, which were essentially management misconduct, because (i) management misconduct is not typically an appropriate basis for the drastic remedy of judicial dissolution; and (ii) in this case, the LLC’s operating agreement specifically limited the Trust’s ability to affect management of the LLC. Emphasizing the Court’s preference for upholding the private ordering of affairs, V.C. Noble found dissolution was not warranted because (i) even where there was disagreement with the LLC’s management there was no deadlock because the voting power was held by one person; (ii) the LLC was not insolvent; and (iii) “[s]imply because things have not worked out as the [T]rust might have liked does not afford the Court a basis for dissolving the limited liability company.” (Transcript dated Feb. 16, 2010, at 44-45).

Supplemental Letter Opinion: In a letter dated February 22, 2010, V.C. Noble supplemented his bench ruling with respect to two cases: Haley v. Talcott, 854 A.2d 86 (Del. Ch. 2004); and In re Arrow Inv. Advisors, LLC, C.A. No. 4091-VCS, 2009 WL 1101682 (Del. Ch. Apr. 23, 2009). The Trust relied heavily on Haley, arguing that the Court there ordered dissolution of the corporation on equitable grounds, rather than on the actual existence of a deadlock. In Haley, the Court required three prerequisites for dissolution pursuant to 8 Del. C. § 273: (i) two 50% stockholders in the corporation; (ii) the stockholders are engaged in a joint venture; and (iii) the stockholders are “unable to agree upon whether to discontinue the business or how to dispose of the assets.” (Letter dated Feb. 22, 2010, at 2). V.C. Noble disagreed with the Trusts’ interpretation of Haley, stating that a critical factor in the Haley Court’s decision was that the “company’s founders envisioned co-equal management, and that one of the members was unable to influence the path upon which the company was traveling.” (Letter dated Feb. 22, 2010, at 3). Comparatively, the LLC in Gutchess was never intended to be a joint venture as evidenced by Homer’s calculated division of equity and voting interests.

Thus, Haley did not apply. The Trust also cited dicta in Arrow Inv. where the Court suggested that dissolution may be appropriate, even in the absence of deadlock, where the petitioner demonstrates that the company’s continued existence would be “obviously futile and would not result in business success.” (Letter dated Feb. 22, 2010, at 4).

Again, V.C. Noble did not find this argument persuasive because the Court in Arrow Inv. emphasized that judicial dissolution was an extreme remedy not to be granted freely. “Moreover, the Trust has not alleged the type of absolute frustration or futility required in the absence of unachievable business purpose and/or deadlock.” (Letter dated Feb. 22, 2010, at 5).

 See excellent and insightful commentary by Peter Mahler on his blog called New York Business Divorce here.