Delaware Corporations Can Keep Federal Securities Law Claims Out of State Courts: Delaware Supreme Court Overrules Sciabacucchi*

*The American Bar Association is publishing a version of this article on its Business Law Today website.

By Jay McMillan

In December 2018, the Delaware Court of Chancery issued an opinion holding that federal-forum charter provisions—those that require plaintiffs to bring actions under the federal securities laws in federal court and not in state court—are “ineffective and invalid.” Sciabacucchi v. Salzberg, 2018 Del. Ch. LEXIS 578 (Del. Ch. Dec. 19, 2018). At that time I wrote: “Assuming that Sciabacucchi is not reversed on appeal, Delaware law allows Delaware corporations to adopt forum selection bylaws or charter provisions governing actions related to the internal affairs of the corporation, but does not allow Delaware corporations to adopt federal-forum provisions governing federal securities law claims.” https://blog.hfk.law/sciabacucchi/ Sciabacucchi has now been reversed by the Delaware Supreme Court. Salzberg v. Sciabacucchi, 2020 Del. LEXIS 100 (Del. Mar. 18, 2020).

A typical federal-forum provision in a certificate of incorporation states that “the federal district courts of the United States of America shall be the exclusive forum for the resolution of any complaint asserting a cause of action arising under the Securities Act of 1933.” The Securities Act of 1933, or the ’33 Act, requires companies offering securities to the public “to make full and fair disclosure of relevant information” by filing registration statements with the United States Securities and Exchange Commission (SEC). The ’33 Act created private causes of action for investors and provided that those claims could be brought in state or federal court. 

The Delaware Supreme Court found that federal-forum charter provisions “can survive a facial challenge under our law.” The high court rejected the Court of Chancery’s conclusion that “constitutive documents of a Delaware corporation cannot bind a plaintiff to a particular forum when the claim does not involve rights or relationships that were established by or under Delaware’s corporate law.”

The Delaware Supreme Court began its analysis with section 102 of the Delaware General Corporation Law (DGCL), which governs matters that may be included in a certificate of incorporation. Section 102(b)(1) of the DGCL allows two types of provisions:

any provision for the management of the business and for the conduct of the affairs of the corporation,

and

any provision creating, defining, limiting and regulating the powers of the corporation, the directors, and the stockholders, or any class of the stockholders, . . . if such provisions are not contrary to the laws of this State.

The court found that a federal-forum provision “could easily fall within either of these broad categories, and thus, is facially valid”:

The drafting, reviewing, and filing of registration statements by a corporation and its directors is an important aspect of a corporation’s management of its business and affairs and of its relationship with its stockholders.

Thus, federal-forum provisions are permissible under both parts of section 102(b)(1) as to the management of the business and affairs of the corporation and as to its relationship with its stockholders.

The court found that federal-forum provisions “can provide a corporation with certain efficiencies in managing the procedural aspects of securities litigation.” When multiple actions are filed in federal and state court, there is no procedural mechanism for consolidating the cases in a single court, resulting in possible inconsistent rulings and other “costs and inefficiencies.” Federal-forum provisions reduce those effects by requiring all actions to be brought in federal court, where they can be transferred to one jurisdiction and consolidated, or can be handled as a single, multidistrict litigation.

The court based its holding that federal-forum provisions are permissible on Cyan, Inc. v. Beaver County Employees Retirement Fund, 138 S. Ct. 1061 (2018), in which the U.S Supreme Court held that class actions based on federal securities laws can be brought in either federal or state court (and cannot be removed to federal court when brought in state court). After Cyan, state-court filings of class actions under federal securities laws “escalated,” with 55 percent more cases filed in state court than in federal court in 2019.

In 2015, the Delaware General Assembly adopted a new section 115 of the DGCL, providing that a Delaware corporation’s charter or bylaws may require “internal corporate claims” to be brought in Delaware courts. The term “internal corporate claims” was defined to include (but was not necessarily limited to) claims of breach of fiduciary duty and claims based on the DGCL. In Sciabacucchi, the Court of Chancery found that federal securities law claims were “external” claims, that section 115 said nothing about external claims, and that it was “understood” that corporate documents could not be used to regulate external claims. The Delaware Supreme Court disagreed, noting that the synopsis to the bill introducing the new section 115 stated that the statute was “not intended to authorize a provision that purports to foreclose suit in a federal court based on federal jurisdiction.” However, federal-forum provisions “do not foreclose suits in federal court”; to the contrary, they direct federal claims to be filed in federal courts. Therefore, federal forum provisions are not inconsistent with section 115.

The appellees argued that section 115 implicitly limited the scope of section 102(b)(1) so as to exclude federal-forum provisions from certificates of incorporation. The Delaware Supreme Court rejected that argument, finding that section 102(b)(1) is “clear and unambiguous” and “does not incorporate Section 115.” The court also found that there is no “irreconcilable conflict” between section 115 and section 102(b)(1) that would cause section 115 to supersede or alter the earlier section. The court harmonized the two sections, finding that section 115 “simply clarifies that for certain claims, Delaware courts may be the only forum, but they cannot be excluded as a forum.”

The Court of Chancery found that federal securities law claims are “external” and therefore cannot be regulated by a certificate of incorporation because “[t]he cause of action does not arise out of or relate to the ownership of the share, but rather from the purchase of the share.” The Delaware Supreme Court rejected that argument too, finding that not all federal securities law claims arise from the purchase rather than the ownership of shares, that existing stockholders can assert such claims, and that other provisions the DGCL “address[] a number of situations involving the purchase or transfer of shares.” The court found that although securities law claims are not concerned with the “internal affairs” of Delaware corporations, neither are they “external.” Instead, such claims are in an “Outer Band” of “intra-corporate” matters covered by section 102(b)(1) of the DGCL but not within the internal affairs of the corporation.

The Delaware Supreme Court embraced the U.S. Supreme Court’s definition of “internal affairs” as matters “peculiar to the relationships among or between the corporation and its current officers, directors, and shareholders.” Edgar v. MITE Corp., 457 U.S. 624, 645 (1982). However, the Delaware Supreme Court found that section 102(b)(1) allows a certificate of incorporation to regulate matters located in the Outer Band of intra-corporate matters beyond internal affairs. This regulation of Outer Band matters does not violate federal law because the U.S. Supreme Court has held that federal law “has no objection to provisions that preclude state litigation of Securities Act claims” (citing Rodriquez de Quijas v. Shearson/American Express, Inc., 490 U.S. 477 (1989)).

Finally, the Delaware Supreme Court found that federal-forum provisions do not “offend principles of horizontal sovereignty” among states, largely because although states are limited in their ability to enact substantive laws that affect other states, forum-selection provisions govern only procedural and not substantive matters. They “regulate where stockholders may file suit, not whether the stockholder may file suit or the kind of remedy that the stockholder may obtain on behalf of herself or the corporation” (quoting Edgar, 457 U.S. at 951–52). As such, they do not “offend sister states [or] exceed the inherent limits of the State’s power.”

The Delaware Supreme Court also noted that federal-forum provisions are less restrictive than Delaware forum provisions because the latter may require stockholder plaintiffs to bring suit far from their home jurisdictions, whereas federal-forum provisions could allow suits to be brought in federal court in any jurisdiction. Nonetheless, combining a Delaware forum charter provision with a federal-forum provision would limit federal securities law claims to the U.S. District Court for the District of Delaware.

Writing in December 2018, I suggested that Delaware corporations should adopt Delaware forum provisions in their certificates of incorporation, but that they could not adopt federal-forum provisions. Now, after the Delaware Supreme Court’s decision in Salzberg v. Sciabacucchi, Delaware corporations can—and should—do both.

James G. (Jay) McMillan is a partner in the Wilmington, Delaware office of Halloran Farkas + Kittila LLP. He concentrates his practice in complex corporate and commercial matters, with a particular focus on litigation in the Delaware Court of Chancery.

Good-Faith Determinations under the CARES Act Paycheck Protection Program*

*The American Bar Association is publishing a version of this article on its Business Law Today website.

By Mark Hobson

  • The CARES Act Paycheck Protection Program requires that small-business applicants for loans make a good-faith certification that the uncertainty of current economic conditions makes the loan request necessary to support ongoing operations.
  • How do applicants determine “necessity,” and how do they ensure they make that determination in “good faith”?
  • Where can applicants turn for guidance?

On March 27, 2020, President Trump signed into law the Coronavirus Aid, Relief, and Economic Security Act (the CARES Act).[1]  In section 1102 of the CARES Act, Congress established the Paycheck Protection Program (PPP), which provides for hundreds of billions of dollars’ worth of loans under section 7(a) of the Small Business Act (SBA)[2] to borrowers who consist of, among others, eligible small businesses.

In applying for an SBA section 7(a) loan under the PPP (a PPP loan), eligible applicants must, among other requirements, be able to make a good-faith certification that the uncertainty of current economic conditions makes the PPP loan request “necessary” to support the ongoing operations of that eligible applicant (a “necessity” certification). However, further complicating the analysis, section 1102(I) of the CARES Act suspends the ordinary requirement that an applicant for a section 7(a) loan be unable to obtain “credit elsewhere”, which is defined in section 3(h) of the SBA[3] to mean the availability to obtain credit from nonfederal sources on reasonable terms and conditions, taking into consideration the prevailing rates and terms in the community in or near where the borrower transacts business, for similar purposes and periods of time. Unlike a borrower for a traditional section 7(a) loan, under the CARES Act, an applicant for a PPP loan is not required to certify that it is unable to obtain credit elsewhere. Instead, PPP loan applicants must consider alternate sources of liquidity in connection with their PPP loan application to assess whether the current economic uncertainty makes its PPP loan request necessary to support its ongoing operations.

On April 23, 2020, the SBA issued then-updated FAQs[4] (SBA FAQs) addressing the “necessity” certification in the PPP loan application but failing to provide any specific standard or quantitative metrics for defining the applicant’s need for the PPP loan. The SBA FAQs, however, did illustrate that:

  • applicants must make a reasonable, good-faith determination of need
    • applicants must assess their ability to access other sources of liquidity sufficient to support their ongoing operations in a manner that is not significantly detrimental to the business
      • applicants who receive a PPP loan should maintain records supporting their determination of need and be ready to demonstrate to a federal regulator the basis for having made their certification

Fortunately, for smaller borrowers—for these purposes, these are borrowers that, together with their affiliates, receive or have received PPP loans in an original, aggregate principal amount of less than $2 million (a Micro-Borrower)—the SBA, in consultation with the U.S. Department of the Treasury, just amended the SBA FAQs to include a safe harbor for Micro-Borrower’s making the “necessity” certification.[5] Under the new safe harbor, Micro-Borrowers will be deemed to have made the “necessity” certification in good faith.

As a consequence of the new safe harbor, the focus on the “necessity” certification has shifted to borrowers who, together with their affiliates, receive or have received PPP loans in an original, aggregate principal amount of $2 million or more (Significant Borrowers); borrowers unable to rely on the safe harbor described above for Micro-Borrowers. Best exemplifying this risk, especially for the larger borrower, is the first official action taken by the Select Subcommittee on the Coronavirus Crisis (the Subcommittee), which is a special investigatory subcommittee established by the U.S. House of Representatives under the House Oversight Committee empowered to oversee that the funds for the PPP loans are used effectively and not subjected to fraud or waste.

On May 8, 2020, the Subcommittee delivered letters to five large, public corporations demanding that they immediately return the PPP loan proceeds that they have received, funds that Congress had intended for small businesses struggling to survive during the coronavirus crisis.[6] These letters were sent to public companies with market capitalization of more than $25 million and 600 employees; PPP loan applicants that sought and received “small business” loans of $10 million or more.  The Subcommittee instructed each of these companies to respond by May 11th as to whether they would return their PPP loan funds; otherwise, the Subcommittee gave them until May 15th to produce all documents and communications (1) between that borrower and the SBA and the Department of the Treasury relating to its PPP loan, and (2) between that borrower and any financial institution relating to its PPP loan, including all applications for a PPP loan. Thus, in its first official action, the Subcommittee sent a clear signal of the real risk that a borrower unable to rely on the Micro-Borrower safe harbor incurs in making the “necessity” certification. Where the Subcommittee will eventually draw the line on sending out similar demands to Significant Borrowers is anyone’s guess. Time, as always, will provide that answer.

What are Significant Borrowers to do in the interim? Unfortunately, the good-faith certification as to the necessity for the PPP loan by the applicant still leaves unanswered questions such as: “How do you define good faith?” “How do you truly determine whether the PPP loan is necessary?” “What law or rule governs these definitions?”

Many commentators have spoken critically about these issues and the ambiguity of these terms. For example, in discussing the process of applying for a PPP loan, Don McGahn, former White House counsel from 2017–18 and now a partner at a large, private law firm, opined in the Wall Street Journal on April 27, 2020,[7] that:

To get a loan, a business must certify that “current economic uncertainty makes this loan request necessary to support the ongoing operations of the Applicant.”

A lax standard, to be sure. But is anyone really going to question that there is “current economic uncertainty”? And that such uncertainty makes a loan request “necessary” to support operations? There is no statutory requirement that a company would go under but for the loan, or that it must, with any degree of certainty, prove need in a detailed way. Hotels and restaurants were given additional statutory leeway: a per location size standard. Regardless of what the goal-post movers now claim they intended, the Cares Act says what it says, and its loose language was sold as a feature, not a bug.

Thus, Mr. McGahn makes the case that every qualified business applying for a PPP loan is capable of making this “necessity” certification in good faith.

However, in the Wall Street Journal the following day,[8] Paul S. Atkins, a former Commissioner with the Securities and Exchange Commission and now CEO of Patomak Global Partners, stirred the pot further by cautioning businesses about taking federal money:

But borrower beware! Businesses with flexibility should seriously consider to what extent accepting the terms of federal loans or other support may be a Faustian bargain. The ultimate cost may dramatically outweigh the temporary gain.

Through the congressional oversight commission established under the Cares Act, the new Special Inspector General for Pandemic Recovery, and numerous other freshly funded inspectors general, the groundwork is already laid for aggressive investigation and review of which businesses received—and how they spent—federal emergency funds.


Thus, back to the question: if a Delaware corporation is applying for a PPP loan, would Delaware General Corporation Law determine whether that entity (and its board of directors) had acted in “good faith” in making its “necessity” certification for a PPP loan? Is not every decision of the board of directors of a Delaware corporation required to be taken in good faith? Remember, section 102(b)(7) of the Delaware General Corporation Law expressly provides that directors cannot be shielded from liability for actions not taken in good faith or breaches of the duty of loyalty.

Moreover, the duty of good faith under Delaware law falls under the protection of the business judgment rule. In Cede & Co. v. Technicolor, Inc., 634 A.2d 345, 360–61 (1993) (citations omitted), the Delaware Supreme Court stated that:

The [business judgment] rule operates as both a procedural guide for litigants and a substantive rule of law. As a rule of evidence, it creates a ‘presumption that in making a business decision, the directors of a corporation acted on an informed basis [i.e., with due care], in good faith and in the honest belief that the action taken was in the best interest of the company.’ The presumption initially attaches to a director-approved transaction within a board’s conferred or apparent authority in the absence of any evidence of ‘fraud, bad faith, or self-dealing in the usual sense of personal profit or betterment.

. . . To rebut the [business judgment] rule, a shareholder plaintiff assumes the burden of providing evidence that directors, in reaching their challenged decision, breached any one of the triads of their fiduciary duty—good faith, loyalty or due care.

If a shareholder plaintiff fails to meet this evidentiary burden, the business judgment rule attaches to protect corporate officers and directors and the decisions they make, and our courts will not second-guess these business judgments.

Thus, an applicant for a PPP loan could argue that its good-faith determination was subject to the business judgment rule, which protects directors from second guessing if they can demonstrate that they have fulfilled their fiduciary duties: the duty of loyalty and duty of care. If the board of directors can demonstrate its members made a good faith determination, then the directors should be protected by the business judgment rule. After all, the business judgment rule dictates that courts defer to decisions taken by the board of directors if the directors acted in good faith and in what they reasonably believed to be in the best interest of the corporation after the exercise of due care. The duty of loyalty, which means that a director must act in good faith and free from any conflict of interest, should not be an issue with respect to a PPP loan. The second component of the director’s fiduciary duty is the duty of care, which requires, first, that directors inform themselves of all material information reasonably available to them prior to making a business decision on behalf of the corporation; and then, after becoming appropriately informed, the directors must act with requisite care in the discharge of their duties. Although the duty of care can be in play with respect to a PPP loan, it is not relevant for determining whether a PPP loan applicant’s “necessity” certification was done in good faith. If that were the case, then the new federal-level Special Inspector General for Pandemic Recovery would, for example, be obliged to look at how each of the states have interpreted the term “good faith,” applying principles of state law (corporation, limited liability company, or limited partnership law, as applicable), in order to determine whether an applicant from that state who applied for a PPP loan satisfied its obligation to make a “necessity” certification in good faith. You know that will not be the case.

The CARES Act is not governed by notions of corporate law because section 7(a) loans involve a federal statutory duty or obligation, which is outside the purview of the Delaware General Corporation Law. The CARES Act is federal law and unfortunately does not include definitions of “necessary,” “necessity,” or “good faith.” So, what are applicants for PPP loans of $2 million or more to do? A good first step is to determine whether there are any SBA rules and interpretations regarding section 7(a) loans that offer guidance in construing these terms.

One SBA publication does in fact shed light on the definition of “good faith”—publication SBA SOP 50 57 from the Office of Capital Access, Small Business Administration, dated March 1, 2013, titled “7(a) Loan Servicing and Liquidation.” Item 16 on page 12 of publication SBA SOP 50 57 provides the following definition of “good faith”:

Good Faith, whether capitalized or not, means the absence of any intention to seek an unfair advantage or to defraud another party; i.e., an honest and sincere intention to fulfill one’s obligations in the conduct or transaction concerned.

Thus, the SBA itself defines “good faith” to include “an honest and sincere intention” and an “absence of any intention to defraud . . . [or to] seek an unfair advantage.” These are helpful standards that businesses can utilize to reduce risks associated with any lack of good faith in applying for a PPP loan.

Also helpful to PPP loan applicants are a question and a comment buried inside a PPP loan guide prepared by the U.S. Senate Committee on Small Business and Entrepreneurship titled, “The Small Business Owner’s Guide to the CARES Act” (the SBA Guide. Taken together, they illustrate the purpose and intent of the CARES Act (italics added):

[Do you need c]apital to cover the cost of retaining employees?

The program would provide cash-flow assistance through 100 percent federally guaranteed loans to employers who maintain their payroll during this emergency.

The SBA Guide therefore makes clear that the primary aim of the PPP is to protect workers and help maintain their jobs; thus, applicants interested in protecting their workers and maintaining their payrolls should apply for a PPP loan, in good faith, especially during this unprecedented time.

Facts and circumstances are paramount. Each business applying for a PPP loan should carefully consider and reasonably document its determinations and considerations of issues such as:

  • whether it is subject to any risk of losing employees because of the economic uncertainty caused by the COVID-19 pandemic
  • whether the PPP loan may help the applicant maintain its payroll during this emergency
  • whether alternative sources of liquidity are available
  • the terms of any alternative source of liquidity, including repayment terms, if any
  • the likelihood and timing of closing on those alternative sources of liquidity
  • whether any additional preference overhang might be created by such alternative sources of liquidity
  • the dilutive effect upon existing owners of pursuing alternative sources of liquidity

So, rather than “borrower beware,” we say, “Significant Borrowers, don’t worry, just act in good faith and be sure to document your determinations!”

Mark Hobson is a partner in the San Francisco, CA, Jackson, WY, and Miami, FL offices of Halloran Farkas + Kittila LLP, where his practice includes domestic and international mergers and acquisitions, venture capital and private equity funds, corporate governance, private placements of securities, joint ventures, asset-based lending, technology transfer arrangements, cross-border deals, and various other business transactions. For more information on the firm, go to HFK.law.


[1] The full text of the CARES Act can be found at this link:  https://www.govinfo.gov/content/pkg/BILLS-116hr748enr/pdf/BILLS-116hr748enr.pdf.

[2] Section 7(a) of the Small Business Act can be found at this link: https://www.sba.gov/sites/default/files/Small%20Business%20Act_0.pdf

[3] See https://www.sba.gov/sites/default/files/Small%20Business%20Act_0.pdf.

[4] full text of the updated the Paycheck Protection Program Loans – Frequently Asked Questions (FAQ) can be found at this link: https://www.sba.gov/sites/default/files/2020-05/Paycheck-Protection-Program-Frequently-Asked-Questions_05%2013%2020.pdf.

[5] See question 46 of the Paycheck Protection Program Loans – Frequently Asked Questions (FAQ), dated May 13, 2020.

[6] See https://oversight.house.gov/news/press-releases/in-first-official-action-house-coronavirus-panel-demands-that-large-public.

[7] Opinion piece in the Wall Street Journal, dated April 27, 2020, by Don McGahn, titled “The Cares Act Game Begins”, posted at this link:  https://www.wsj.com/articles/the-cares-act-blame-game-begins-11588026158.

[8] Opinion piece in the Wall Street Journal, dated April 28, 2020, by Paul S. Atkins, titled “Borrower Beware: Cares Loans Carry a Steep Cost”, posted at this link:   https://www.wsj.com/articles/borrower-beware-cares-loans-carry-a-steep-cost-11588113575.

Delaware Court of Chancery Gives the Little Guy a Break on E-Discovery Costs

By Jay McMillan

The cost of producing documents and electronically stored information (“ESI”) in civil litigation today can be prohibitive for small companies and individual litigants—especially given the presumed need to hire third-party e‑discovery vendors to conduct forensic searches of email files, text messages, and other sources of ESI. In McCabe’s Mechanical Service Inc. v. Ballweg, 2020 Del. Ch. LEXIS 141 (Order, Apr. 9, 2020), the individual defendant, Ballweg, responded to requests for production of documents by searching his own emails and text messages and producing responsive documents.

Such “self-production” is usually frowned upon by the Delaware Court of Chancery. However, in Ballweg, the defendant asserted that his production was “adequate and complete.” The plaintiff, McCabe’s, was unconvinced, and demanded that Ballweg hire a third-party e-discovery vendor to conduct a forensic search of his files. McCabe’s filed a motion to compel discovery and Ballweg opposed, arguing that a third-party vendor “was an unnecessary expense given the scope of the claim.”

Vice Chancellor Sam Glasscock III came up with a creative solution, issuing an order first requiring Ballweg to provide an affidavit affirming “that he had responded fully to all relevant document requests, including requests for ESI.” Then, if McCabe’s still maintained that a third-party vendor was necessary, the parties would confer and agree on a vendor to conduct the searches—but at McCabe’s expense. If the third-party vendor’s search of Ballweg’s ESI revealed either that his production was incomplete or that he had spoliated evidence, then the cost of the third-party vendor would be shifted to Ballweg.

The Court of Chancery Rules were amended as of July 1, 2019 to adopt the language from the Federal Rules of Civil Procedure that allows a party to take discovery into “any non‑privileged matter that is relevant to any party’s claim or defense and proportional to the needs of the case.” Vice Chancellor Glasscock’s order in Ballweg appears to be a significant application of that “proportionality” standard. It could easily serve as a model for other cases in which the cost of hiring an e‑discovery vendor is not “proportional to the needs of the case.” Shifting costs first to the party seeking discovery and then to the producing party if the production is inadequate would create positive incentives on both sides, encouraging the requesting party to accept a less expensive mode of production while also motivating the producing party to conduct a diligent search and make a complete production.

Following the example set in Ballweg, litigation counsel representing individual or small-business parties should consider seeking provisions in a discovery plan or order that would implement the Ballweg procedure—which could substantially reduce the burden and expense of ESI production on their clients.

James G. (Jay) McMillan is a partner in the Wilmington, Delaware office of Halloran Farkas + Kittila LLP. He concentrates his practice in complex corporate and commercial matters, with a particular focus on litigation in the Delaware Court of Chancery. For more information on the firm, visit hfk.law.

Acting Manager of LLC Subject to Personal Jurisdiction in Delaware: Case Law Precedents “Not Persuasive”*

By Jay McMillan
Managers of Delaware limited liability companies can be compelled to appear in Delaware courts if they are either formally named as managers under an LLC’s operating agreement (“formal managers”) or if they “participate[] materially in the management of the limited liability company” (“acting managers”). Under Section 18-109(a) of the Delaware LLC Act, serving as either a formal manager or an acting manager constitutes consent to service of process in a lawsuit and with it the exercise of personal jurisdiction by the Delaware courts. 6 Del. C. § 18-109(a).

LLCs can be either “member-managed,” where the vote of holders of a majority of the membership interests governs, or “manager-managed,” where the LLC agreement provides for a formal manager. In Metro Storage International LLC v. Harron, 2019 Del. Ch. LEXIS 272 (Del. Ch. July 19, 2019), the defendant, Harron, served as the acting manager of two Delaware LLCs. Although the LLCs were manager-managed, Harron was not the formal manager of either one. Based on the fact that Harron did manage the day-to-day operations of the two LLCs, Vice Chancellor J. Travis Laster of the Delaware Court of Chancery found that Harron participated materially in their management and thus satisfied the plain language of the statute.

Harron argued, however, that to be an acting manager under the statute, a person must occupy a “control or decision-making role” and that any time an LLC agreement vests authority in a formal manager, another person cannot have a control or decision-making role and the LLC therefore cannot also have an acting manager. He also argued that a person who participates in management of an LLC as an agent for another cannot be an acting manager. The Court rejected those arguments.

The “Control Overlay” Argument
The Court referred to the first argument as the “control overlay” argument based on cases in which Delaware courts “added a layer to the material-participation test by holding that persons are not amenable to service as acting managers unless they occupy a ‘control or decision-making role.’” In the first such case, Florida R & D Fund Investors, LLC v. Florida BOCA/Deerfield R & D Investors, LLC, 2013 Del. Ch. LEXIS 216 (Del. Ch. Aug. 30, 2013), the Court of Chancery “mentioned the phrase ‘control or decision-making role’ once, in passing, without citing authority to support the formulation, and without providing any reason for departing from the statutory material-participation test.” The Court in Metro Storage found that “Later decisions have followed its language without testing the foundation’s footings.”

In the second case, Wakley Ltd. v. Ensotran, LLC, 2014 U.S. Dist. LEXIS 34918 (D. Del. Mar. 18, 2014), the United States District Court for the District of Delaware, following Florida R & D, “made the control overlay more onerous by interpreting a ‘control or decision-making role’ as requiring that the person named as a defendant be ‘effectively running [the entity’s] entire business.’” The District Court “elevated the control overlay from a passing phrase to an operative test, while further elevating the necessary level of involvement to require ‘effectively running [the LLC’s] entire business.’”

The Court in Metro Storage found that a more recent opinion of the Delaware Supreme Court, Hazout v. Tsang Mun Ting, 134 A.3d 274 (Del. 2016), “requires abandoning” the control overlay. Hazout addressed the analogous consent-to-service statute for directors and officers of Delaware corporations, 10 Del. C. § 3114. That statute provides for personal jurisdiction in two kinds of cases: (i) “all civil actions or proceedings brought in this State, by or on behalf of, or against such corporation, in which such officer is a necessary or proper party,” and (ii) “any action or proceeding against such officer for violation of a duty in such capacity.”

But in Hana Ranch, Inc. v. Lent, 424 A.2d 28 (Del. Ch. 1980), the Court of Chancery held that Section 3114 applied only to “claims asserting that the defendant had breached duties owed to the corporation or its stockholders,” abrogating the “necessary or proper party” portion of the statute. Hana Ranch was followed for 36 years, until the Delaware Supreme Court rejected it in Hazout, finding “it is our obligation to give effect to the plain language of statutes to the extent we can do so without offending any supervening constitutional limits.” The Delaware Supreme Court thus restored the Delaware courts’ full range of personal jurisdiction over corporate officers and directors in keeping with the plain language of the statute.

In Metro Storage, the Court of Chancery found that the same reasoning should apply to the consent statute for managers of LLCs; the control overlay violates the plain language of 6 Del. C. § 18-109(a), which provides for jurisdiction over persons who participate materially in the management of a Delaware LLC—the statute is not limited by its terms to persons in a control or decision-making role.

The “Formal Manager Designation” Argument
Next, Harron argued “that a defendant cannot serve as an acting manager if the operative LLC agreement contains a formal manager designation.” In Fisk Ventures, LLC v. Segal, 2008 Del. Ch. LEXIS 158 (Del. Ch. May 7, 2008), the defendant, Fisk Johnson, was a major investor who had the right to appoint two members to the LLC’s “Board of Member Representatives.” The plaintiff, Segal, argued that Johnson was an acting manager because he “(i) controlled his board appointees and (ii) participated in the management of [the LLC] through broad veto rights.” The Court of Chancery in Fisk Ventures rejected the first part of the argument, finding that Johnson did not materially participate in management.

The Court in Fisk Ventures also rejected the second part of the argument. The company’s LLC agreement provided that the members of the LLC “shall conduct, direct and exercise full control over all activities of the company through their representatives of the board.” The Court concluded that “the designation of the board as the formal manager precluded Johnson from qualifying as an acting manager.” The Court in Metro Storage found that, because the material participation test was not met in Fisk Ventures, “[t]he reference to the formal manager designation in the… LLC agreement did not add anything to the analysis.”

In support of the formal manager designation argument, Harron cited three cases, Wakley Ltd. v. Ensotran, LLC, 2014 U.S. Dist. LEXIS 34918 (D. Del. Mar. 18, 2014) (discussed above), In re Dissolution of Arctic Ease, 2016 Del. Ch. LEXIS 185 (Del. Ch. Dec. 9, 2016), and CelestialRX Investments, LLC v. Krivulka, 2019 Del. Ch. LEXIS 102 (Del. Ch. Mar. 27, 2019). The Court found that those cases were “not persuasive precedents.” In Wakley, the District Court found that although a defendant had “broad authority,” “her power was ‘subject to the decisions and instructions of the board.” The Court concluded that the defendant “is not a ‘manager’ under § 18-109(a)(ii) because she did not participate materially in the management of [the LLC].” The Court in Metro Storage found that “This brief reference does not appear to have played a meaningful role in the court’s analysis.”

In Arctic Ease, the LLC’s managing member argued that the Court of Chancery had personal jurisdiction over an investor because the investor participated materially in management. The Court found that because the LLC had a managing member who was empowered by the LLC agreement to manage the company, the investor “could not have served in the type of ‘control or decision-making role’ necessary to satisfy the control overlay.”

Similarly, in CelestialRX, the Court of Chancery found that a former board member “could not have participated materially in management because he no longer occupied a control or decision-making role.”

The Court in Metro Storage found that in all three cases the factual allegations did not support jurisdiction under the plain-language test, and that they all “reached outcomes for which the formal manager designation was unnecessary.” The Court also found that the formal manager designation argument derived from the control overlay argument that it had already rejected and that it originated from a misreading of case law. The Court concluded “Because LLCs have flexible governance structures and often operate with a relatively high degree of informality, the broader formulation enables Delaware courts to exercise personal jurisdiction over key individuals who take action on behalf of the entity.”

The “Agency Shield” Argument
Harron’s third and final argument was that “if a person participates materially in the management of an LLC while acting as an agent, then the person’s actions as agent cannot support a finding of material participation because the agent is acting on behalf of his principal.” In Wakley, the Court stated that the plaintiff failed to convince the Court that the defendants “were not acting at the direction of, and as representatives for” the investor who appointed them. The Court in Metro Storage rejected this “agency shield” argument, finding that it was a version of the “fiduciary shield” doctrine, “which holds that when an officer or other agent for an entity engages in acts within a jurisdiction in an official capacity, the agent is not subject to jurisdiction based on official acts, but only for acts committed in a personal capacity.”

The Court found that “Scholars have thoroughly critiqued the fiduciary shield and argued for its rejection,” that it conflicts with the Delaware long-arm statute, 10 Del. C. § 3104(c)(1), which authorizes service of process on a person who engages in forum-directed activity “in person or through an agent,” and the common-law agency theory of jurisdiction, which allows the exercise of jurisdiction over a non-resident principal by attributing the jurisdictional contacts of the agent to the principal.

The Court thus rejected the agency shield argument, and concluded that Section 18-109(a)(ii) can be used to serve a person with process “even if the person acted as an agent of the LLC or its formal manager.”

By rejecting Harron’s arguments and hewing to the plain language of the LLC Act, the Court of Chancery confirmed the full range of jurisdiction of Delaware courts over acting managers of Delaware LLCs in keeping with the statute. Acting managers of Delaware LLCs and their counsel should be aware that any person who participates materially in the management of a Delaware LLC can be haled into a Delaware court in any case “involving or relating to the business of the limited liability company or a violation by the manager . . . of a duty to the limited liability company or any member of the limited liability company….” 6 Del. C. § 18-109(a).

* This blog post is a reprint of an article to be published in the August 2019 edition of the newsletter of the ABA Business Section’s Middle Market and Small Business Committee.

James G. (Jay) McMillan is a partner in the Wilmington, Delaware office of Halloran Farkas + Kittila LLP. He concentrates his practice in complex corporate and commercial matters, with a particular focus on litigation in the Delaware Court of Chancery. For more information on the firm, visit hfk.law.

Accountants Win Dismissal of Claim for Negligent Misrepresentation in Delaware Court of Chancery

By Jay McMillan

Justice Cardozo, writing on New York law, “expressed doubt over expansive liability for accountants, stating that ‘[a]f liability for negligence exists, a thoughtless slip or blunder, the failure to detect a theft or forgery beneath the cover of deceptive entries, may expose accountants to a liability in an indeterminate amount for an indeterminate time to an indeterminate class.” Under Delaware law, while it is possible for a third party to state a claim against an auditor for negligent misrepresentation, a recent case shows how high the pleading bar must be.

In Otto Candies, LLC et al. v. KPMG LLP et al., C.A. No. 2018-0435-MTZ (Del. Ch. Feb. 28, 2019), a group of creditors and bondholders sued the accounting firm KPMG and two of its affiliates for negligent misrepresentation based on KPMG’s audits of a Mexican company, Oceanografía S.A. de C.V. (“OSA”), and OSA’s banker, Banamex, a Mexican subsidiary of Citigroup, Inc. OSA was at one time the largest offshore oil and gas services company in Latin America. OSA allegedly scammed Citigroup for years using forged and fraudulent invoices. When the fraud was exposed, Citigroup withdrew its credit line and OSA “crumpled into bankruptcy.”

OSA’s creditors and bondholders sued KPMG, along with its Mexican subsidiary and its Swiss parent, alleging that the three KPMG entities negligently failed to catch OSA’s frauds in their audits of OSA, Citigroup, and Banamex. Vice Chancellor Morgan T. Zurn of the Delaware Court of Chancery dismissed the claims against the Mexican and Swiss KPMG entities based on lack of personal jurisdiction and forum non conveniens. She dismissed the claims against KPMG US for failure to state a claim and failure to plead negligent misrepresentation with the required particularity.

The Court found that the claim against KPMG would be dismissed under Delaware law, New York law, or Mexican law. First, under Delaware law, the Court found that to state a claim for negligent misrepresentation, plaintiffs “must adequately plead that (1) the defendant had a pecuniary duty to provide accurate information, (2) the defendant supplied false information, (3) the defendant failed to exercise reasonable care in obtaining or communicating the information, and (4) the plaintiff[s] suffered a pecuniary loss caused by justifiable reliance upon the false information.”

The Court found that the plaintiffs failed to plead the first element of negligent misrepresentation, a duty owed by KPMG to the plaintiffs. Under Section 552 of the Restatement (Second) of Torts, a duty is owed to “the person or one of a limited group of persons for whose benefit and guidance [the supplier of information] intends to supply the information or knows that the recipient intends to supply it.” Comment h to Section 552 of the Restatement explains “[i]t is enough that the maker of the representation intends it to reach and influence either a particular person or persons, known to him, or a group or class of persons, distinct from the much larger class who might reasonably be expected sooner or later to have access to the information and foreseeably to take some action in reliance upon it.”

So the issue in Otto Candies was whether the plaintiffs were “a group or class of persons” that KPMG intended the information “to reach and influence” or whether the plaintiffs were part of “the much larger class” to which KPMG did not owe a duty.

The plaintiffs relied on Carello v. PricewaterhouseCoopers LLP, 2002 WL 1454111, at *8 (Del. Super. Ct. July 3, 2002), in which the Delaware Superior Court permitted negligent misrepresentation claims against an auditor to go forward. In Carello, the plaintiffs were the sole stockholders of a company that was sold subject to earn-out payments to be based on future performance. The buyer filed for bankruptcy shortly after the acquisition and could not meet its earn-out obligations. The seller sued the buyer’s auditor, alleging that it “misrepresented the buyer’s financial health and specifically advised the sellers that the acquisition was a good deal.” There was evidence that the auditor “may have prepared its audits to influence the acquisition of plaintiffs’ company.”

The Court in Otto Candies found that an auditor is not liable to non-contractual parties unless the auditor intends to supply the information, or knows that the client intends to supply it, “for the benefit and guidance of a limited group” and the auditor “must also know, or have reason to know, how that group intends to use the information.” In other words, the auditor “has or should have (a) knowledge of a limited, but perhaps unnamed, group, as well as (b) knowledge of the actual financial transactions that the information is designed to influence.”

The Court concluded that those criteria were not met. KPMG US audited Citigroup, which only did business with OSA through its Mexican subsidiary, Banamex. KPMG Mexico, and not KPMG US, audited OSA. Thus, the plaintiffs had only “distant relationships” with KPMG US. “Creditors with distant relationships to an auditor, like Plaintiffs to KPMG US, may be able to allege that the auditor intended to supply information to that creditor or knew the auditor’s client would do so.” But the Court concluded that the plaintiffs had failed to adequately plead that KPMG US (or even KPMG Mexico) “knew of, or intended to influence, the myriad transactions in which Plaintiffs engaged with OSA.” The plaintiffs’ relationship to KPMG US was too distant.

The Court also found that the plaintiffs failed to plead the element of “justifiable reliance” “with particularity” as required for a claim of negligent misrepresentation. The 520-paragraph complaint contained only conclusory allegations of reliance on KPMG’s audits. The Court again distinguished Carello, finding that in that case “the sellers had pled that the buyer’s auditor specifically advised the seller plaintiffs that the acquisition was a ‘good deal,’ and that the auditor may have slanted the financial statements to be more attractive to those sellers.” The plaintiffs in Otto Candies, by contrast, did not allege that KPMG US was involved in OSA’s frauds or that they relied on communications with KPMG US. Nor did the plaintiffs identify any specific audits, reports or financial statements they allegedly relied on. Under Delaware law, the plaintiffs failed to state a claim for negligent misrepresentation.

Under New York law, the Court found that the standard for pleading a claim of negligent misrepresentation is “more chary of Plaintiffs’ claims than Delaware’s” and that the result would therefore be the same. Under New York law, “(1) the accountants must have been aware that the financial reports were to be used for a particular purpose or purposes; (2) in the furtherance of which a known party or parties was intended to rely; and (3) there must have been some conduct on the part of the accountants linking them to that party or parties, which evinces the accountants’ understanding of that party or parties’ reliance.” (quoting Credit Alliance Corp. v. Arthur Andersen & Co., 483 N.E.2d 110, 118 (N.Y. 1985), amended, 489 N.E.2d 249 (N.Y. 1985)). New York law is “designed to limit liability in cases like this one.”

Under Mexican law, the Court considered declarations submitted by the parties’ experts. The plaintiffs’ expert argued that Mexican law applies a “broad standard” that “leaves room for third-party auditor liability.” The Court found that that would be “enough to preclude dismissal” of the plaintiffs’ negligent misrepresentation claim. However, the plaintiffs “falter[ed] on causation” for extra-contractual damages. The Court found that it was “not reasonably conceivable that the Audits directly and immediately caused Plaintiffs’ harm. That harm flows principally from OSA’s fraud and its subsequent filing for bankruptcy protections, or potentially from misconduct by Citigroup and Banamex.” Thus, Mexican law would arrive at the same result as Delaware or New York law through a different path.

Auditors Can Be Held Liable for Negligent Misrepresentation by Third Parties

Under Delaware law, it is possible for a third party to state a claim for negligent misrepresentation against an auditor. The third party must allege – with particularity – that the auditor (1) intended to supply information, or knew that its client intended to supply it, for the benefit and guidance of a limited group, and (2) knew of the actual financial transactions that the information was designed to influence. The third party must also allege with particularity its reliance on specific information and when it relied on it. In Otto Candies, the creditors and bondholders failed to state a claim because their relationship to KPMG US was too distant and because they did not adequately allege reliance. But in Carello the plaintiffs successfully pled a claim for negligent misrepresentation because they alleged that the auditor was aware of the plaintiffs as sellers and was aware of and supported the acquisition of the plaintiffs’ company by its client, and that the plaintiffs relied on the auditor’s reports and representations.

In short, accountants, and the lawyers advising them, should be especially wary when asked to provide information in connection with specific transactions with limited groups, and should in all events avoid “slanting” information to make a transaction more attractive, or opining to the client’s counter-party that the transaction is “a good deal.”

James G. (Jay) McMillan is a partner in the Wilmington, Delaware office of Halloran Farkas + Kittila LLP.  He concentrates his practice in complex corporate and commercial matters, with a particular focus on litigation in the Delaware Court of Chancery.  For more information on the firm, visit hfk.law.

 

Stockholders Can Hire Lawyers to Monitor Investments for Potential Litigation: Delaware Court of Chancery Gives Corporate Books to Law Firm Retained by Institutional Investor

By Jay McMillan

As I reported in November 2017, the Delaware Court of Chancery, in Wilkinson v. A. Schulman, Inc., C.A. No. 2017-0138-JTL, 2017 Del. Ch. LEXIS 798 (Del. Ch. Nov. 13, 2017), ruled that stockholder plaintiffs in books-and-records actions under Section 220 of the Delaware General Corporation Law are required to have “substantive involvement” in the litigation. In Wilkinson, Vice Chancellor J. Travis Laster rejected a demand for corporate books and records based on his finding that the purpose for inspection stated in the plaintiff’s demand was not his true purpose. Jack Wilkinson, an individual investor, responded to a law firm’s press release announcing an investigation of potential wrongdoing at A. Schulman, Inc. Wilkinson’s purpose, as revealed in discovery, was to investigate a corporate loss following a merger. His lawyers served a books-and-records demand on A. Schulman in his name, stating that his purpose was to investigate excessive compensation paid to the corporation’s chief executive officer upon his retirement. Wilkinson and his attorneys subsequently filed a books-and-records action in the Delaware Court of Chancery. The Court dismissed the action, finding that “Wilkinson simply lent his name to a lawyer-driven effort by entrepreneurial plaintiffs’ counsel” and that he “did not take any steps to confirm the accuracy of the allegations in the complaint.”

Last month, in Inter-Local Pension Fund GCC/IBT v. Calgon Carbon Corp., C.A. No. 2017-0910-MTZ, 2018 Del. Ch. LEXIS 587 (Del. Ch. Jan. 25, 2018), Vice Chancellor Morgan T. Zurn distinguished Wilkinson, finding that the Calgon plaintiff, an institutional investor referred to as the Fund, could rely on its outside counsel (prominent class-action plaintiffs’ firm Robbins Geller Rudman & Dowd LLP) to “monitor” the Fund’s investments, identify potential legal issues, draft books-and-records demands, and prosecute subsequent litigation. Although the Fund’s representative testified that Robbins Geller determined the requests in the books-and-records demand, and that the Fund did not independently confirm the allegations, the Court ruled in the Fund’s favor, finding that it was not necessary for the plaintiff to “originally conceive of” the purposes for the demand.

The Court in Calgon held that:

“Stockholders are entitled to hire counsel to review and monitor their portfolios for potential mismanagement or wrongdoing. They are also entitled to rely on that counsel to raise concerns, to advise them on how to remedy those concerns, and to pursue appropriate remedies.”

The Court accepted the Fund’s argument that the action was not “lawyer-driven” like that in Wilkinson. The Court distinguished the prior case because in Wilkinson the plaintiff admittedly had a purpose that was different from the purpose stated by his lawyers in his demand. In Calgon, the Court found that the Fund’s purpose “aligns with” the purpose stated in the demand and that Robbins Geller had not “usurped the process for a different purpose” like the lawyers did in Wilkinson. The Court concluded “[t]o hold otherwise would largely leave Section 220 open only to sophisticated stockholders with the financial or legal training necessary to independently spot relevant corporate governance and similar issues.”

While Wilkinson suggested that stockholder plaintiffs must be self-motivated and substantively involved in books-and-records actions (although not necessarily in plenary litigation), Calgon allows investors to hire attorneys to monitor their investment portfolios, identify potential litigation, draft books-and-records demands, and prosecute subsequent litigation with limited involvement by the investor. In Calgon, the Fund argued that Robbins Geller served the same function as in-house counsel would in monitoring the Fund’s investments, and that the litigation was not “lawyer-driven” because the Fund had an established relationship with Robbins Geller. In Wilkinson, the case involved a “serial plaintiff” who had been involved in several cases that were settled for little consideration other than attorneys’ fees.

Wilkinson and Calgon taken together suggest that stockholder plaintiffs’ law firms should work closely with their clients in bringing books-and-records actions, and should communicate effectively with their clients to determine the clients’ true purposes and expectations. Plaintiffs in books-and-records actions risk dismissal where discovery can reveal a disconnect, as in Wilkinson, between the client’s purposes and those of his or her attorneys.

James G. (Jay) McMillan is a partner in the Wilmington, Delaware office of Halloran Farkas + Kittila LLP.  He concentrates his practice in complex corporate and commercial matters, with a particular focus on litigation in the Delaware Court of Chancery.  For more information on the firm, visit hfk.law.

Corporations Cannot Bar Plaintiffs from Bringing Securities Law Claims in State Court: Delaware Court of Chancery Finds Federal-Forum Charter Provisions “Ineffective and Invalid”

By Jay McMillan

Delaware corporations can adopt forum-selection bylaws naming Delaware as the exclusive forum for stockholder claims related to the internal affairs of the corporation. However, based on a recent Court of Chancery ruling, Delaware corporations cannot adopt charter provisions that require plaintiffs to go to federal court (rather than state court) to assert any claims made under the federal securities laws.

Forum selection bylaws require stockholder plaintiffs to bring actions for breach of fiduciary duty and other matters related to the internal affairs of a corporation in a specific jurisdiction. In 2013, Chief Justice Leo E. Strine, Jr., then serving on the Court of Chancery, ruled in Boilermakers Local 154 Retirement Fund v. Chevron Corp., 73 A.3d 934 (Del. Ch. 2013), that Delaware forum selection bylaws are valid and enforceable.

On the other hand, federal-forum charter provisions require plaintiffs to bring actions under the federal securities laws in federal court and not in state court. In an opinion issued on December 19, 2018, Sciabacucchi v. Salzberg, Del. Ch. C.A. No. 2017-0931-JTL, Vice Chancellor J. Travis Laster ruled that federal-forum charter provisions are “ineffective and invalid.” The difference is that forum selection bylaws apply only to actions involving the internal affairs of the corporation, while federal forum provisions apply to the external act of buying shares—at which point the buyer is not yet a stockholder of the corporation.

The “internal affairs doctrine” means, for example, that “Delaware corporate law can specify the rights, powers, and privileges of a share of stock, determine who holds a corporate office, and adjudicate the fiduciary relationships that exist within the corporate form.” In other words, internal affairs include ownership of stock, the roles of officers and directors, and fiduciary duties. However, Delaware’s authority over a Delaware corporation does not extend to the corporation’s “external relationships, particularly when the laws of other sovereigns govern those relationships.” Federal law governs the relationships between buyers and sellers of securities. Delaware law governs the relationships between Delaware corporations and their directors, officers, and stockholders.

In Sciabacucchi, three Delaware corporations, Blue Apron Holdings, Inc., Roku, Inc., and Stitch Fix, Inc., launched initial public offerings in 2017. Each of the three corporations adopted a provision in its certificate of incorporation stating that “the federal district courts of the United States of America shall be the exclusive forum for the resolution of any complaint asserting a cause of action arising under the Securities Act of 1933.” The Securities Act of 1933, or the ’33 Act, requires companies offering securities to the public “to make full and fair disclosure of relevant information” by filing registration statements with the United States Securities and Exchange Commission (SEC). The ’33 Act created private causes of action for investors and provided that those claims could be brought in state or federal court. On March 20, 2018, in Cyan, Inc. v. Beaver County Employees’ Retirement Fund, 138 S. Ct. 1061, the Supreme Court of the United States confirmed that ’33 Act claims can be brought in state or federal court and, if brought in state court, cannot be removed to federal court.

In Sciabacucchi, the plaintiff, who held shares of stock in each of the three corporations, brought an action in the Delaware Court of Chancery challenging the federal forum provisions and seeking a declaration that the provisions were invalid. The parties filed cross-motions for summary judgment. The Court found that the matter was ripe for adjudication because of the likely deterrent effect of the provisions on plaintiffs who would otherwise bring their actions in state court, and the likelihood that similar provisions would be adopted by other corporations.

The Court traced the origin of corporate forum-selection provisions to “an epidemic of stockholder litigation,” including “frequently meritless” actions that were settled for “non-monetary relief and an award of attorneys’ fees.” In 2010, Vice Chancellor Laster suggested in In re Revlon, Inc. Shareholders Litigation, 990 A.2d 940, that the filing of multiple lawsuits in multiple jurisdictions could be mitigated by the adoption of bylaws requiring stockholder litigation to be brought in the jurisdiction of incorporation. In 2013, then-Chancellor Strine held in Boilermakers that those bylaws were valid under Delaware law. By August 2014, 746 publicly traded corporations had adopted such forum-selection bylaws.

In 2015, the Delaware General Assembly codified the holding of Boilermakers by adopting a new Section 115 of the Delaware General Corporation Law (DGCL). Section 115 provides that a Delaware corporation’s charter or bylaws may require “internal corporate claims” to be brought in Delaware courts. The term “internal corporate claims” was defined to include claims of breach of fiduciary duty and claims based on the DGCL. However, the statute said nothing about external claims, including securities law claims—it was understood that corporate documents could not be used to regulate external claims.

The DGCL contains provisions stating the subjects (in short, internal affairs) that may be addressed by bylaws and certificates of incorporation. Compare 8 Del. C. § 102(b)(1) (charters) and 8 Del. C. § 109(b) (bylaws). Based on the similarities between the provisions, Vice Chancellor Laster in Sciabacucchi found that the holding of Boilermakers with respect to bylaws should apply equally to certificates of incorporation.

The Court found that because securities law claims are based on the purchase of securities, as opposed to the ownership of the shares, securities law claims are external to the affairs of the corporation. “The cause of action does not arise out of or relate to the ownership of the share, but rather from the purchase of the share.” Claims are governed by Delaware law where they relate to the stockholder “qua” stockholder. The Court concluded that federal-forum provisions “purport to regulate the forum in which parties external to the corporation (purchasers of securities) can sue under a body of law external to the corporate contract (the 1933 Act). They cannot accomplish that feat, rendering the provisions ineffective.”

Assuming that Sciabacucchi is not reversed on appeal, Delaware law allows Delaware corporations to adopt forum selection bylaws or charter provisions governing actions related to the internal affairs of the corporation, but does not allow Delaware corporations to adopt federal-forum provisions governing federal securities law claims. Delaware corporations can and should adopt bylaws or charter provisions naming Delaware as the exclusive forum for actions related to the internal affairs of the corporation. Those provisions are effective to limit multi-jurisdiction stockholder litigation. Delaware corporations may not, however, adopt bylaws or charter provisions that name the federal courts as the exclusive forum for federal securities law actions. Those actions can still be brought in any state or federal court that has jurisdiction over the defendants.

James G. (Jay) McMillan is a partner in the Wilmington, Delaware office of Halloran Farkas + Kittila LLP.  He concentrates his practice in complex corporate and commercial matters, with a particular focus on litigation in the Delaware Court of Chancery.  For more information on the firm, visit hfk.law.

Passengers Will Please Refrain: Delaware Court of Chancery Upholds Contractual Waiver of Statutory Appraisal Rights in a Merger

By Jay McMillan

Until recently, it was unclear whether a stockholder’s statutory right to appraisal of shares following a merger could be waived by contract.  In Manti Holdings, LLC v. Authentix Acquisition Co., C.A. No. 2017-0887-SG (Oct. 1, 2018), Vice Chancellor Sam Glasscock III of the Delaware Court of Chancery rejected a stockholder’s argument that allowing waiver of appraisal rights by contract was against public policy.  Under Section 262 of the Delaware General Corporation Law, a stockholder in a Delaware corporation may dissent from a merger if the stockholder does not vote in favor of or consent in writing to the merger.  Dissenting stockholders are entitled to appraisal of their shares by the Court of Chancery and are entitled to receive the fair value of their shares as determined by the Court.  In Manti Holdings, the Court of Chancery held for the first time that the statutory right to appraisal can be waived by contract.

The corporation, Authentix, merged with a third party in a transaction that resulted in the appraisal petitioners and other common stockholders receiving little or no consideration for their shares.  Authentix and the petitioners were parties to a stockholders’ agreement that required the parties to consent to a defined “Company Sale” – which occurred in the merger – and to “refrain from the exercise of appraisal rights” with respect to a Company Sale.  The Court stated that “[d]emonstrating a waiver of the statutory right to appraisal requires language evincing the clear intent to waive.”

The petitioners argued, first, that the stockholders’ agreement provided “[t]his agreement, and the respective rights and obligations of the Parties, shall terminate upon the … consummation of a Company Sale,” and their obligation to refrain from exercising appraisal rights thus terminated upon the closing of the merger, allowing them to seek appraisal post-closing.  The petitioners argued that the stockholders’ agreement could have, but did not, state that the right to appraisal was “waived” or “void” upon approval of a sale.  The Court, however, demonstrated a common-sense approach to contract interpretation, finding that the “refrain” language was not ambiguous and that “[n]o contracting party, agreeing to the quoted language, would consider itself free to exercise appraisal rights.”

(The Court, in one of its arcane pop-culture references, contrasted the petitioners’ effort to find ambiguity in the word “refrain” with Arlo Guthrie’s use of the word in a song about a train called “City of New Orleans”: “the conductor sings his songs again, the passengers will please refrain.”)

Second, the petitioners argued that their obligation to refrain from exercising appraisal rights was not triggered because the stockholders’ agreement provided that the obligation would only arise if the company’s majority stockholder received the same value as other stockholders, and that condition was not met.  The Court rejected that argument also, finding that the provision the petitioners relied on only applied in a sale or transfer of the company’s stock, and not in a merger, such as occurred here.  The Court concluded that the petitioners were bound by the stockholders’ agreement to consent to the merger, not to object, and not to exercise appraisal rights.

Third, the petitioners argued that the waiver of appraisal rights, if enforceable, was not enforceable by the company.  The Court found, however, that Authentix was a party to the stockholders’ agreement and would be the respondent in any appraisal action, and that any duty to pay would fall on the company.  Again demonstrating a common-sense approach, the Court concluded that the petitioners “knew they would be bound” by the stockholders’ agreement at the time of a Company Sale.

Finally, the petitioners argued that enforcing the obligation to refrain from exercising appraisal rights was precluded by public policy.  Under Section 151(a) of the Delaware General Corporation Law, limitations on classes of stock must be stated in or derived from the certificate of incorporation.  The petitioners argued that the stockholders’ agreement would allow the company’s board to circumvent the statute by placing restrictions on a class of stock by contract.  The Court rejected that argument also, finding that imposing limitations on stockholders’ rights under contract was “not the equivalent” of imposing limitations on classes of stock under Section 151(a).  The Court concluded that the stockholders’ agreement “did not restrict the appraisal rights of the classes of stock held by the Petitioners; instead, the Petitioners, by entering the [stockholders’ agreement], agreed to forbear from exercising that right.”

The Court noted that the stockholders’ agreement “was presumably to the benefit of all parties” and that the waiver of appraisal rights was included “to entice investment” and “make the Company more attractive to potential buyers.”  It is now clear that such contractual waivers are enforceable under Delaware law, at least where, as in Manti Holdings, they require stockholders to “refrain from the exercise of appraisal rights.”

Update:  The petitioners have filed a motion for reargument and have identified five grounds for appeal.  The Court has scheduled argument on the motion for November 26, 2018.  I will post a further update as soon as the Court issues a ruling.

James G. (Jay) McMillan is a partner in the Wilmington, Delaware office of Halloran Farkas + Kittila LLP.  He concentrates his practice in complex corporate and commercial matters, with a particular focus on litigation in the Delaware Court of Chancery.  For more information on the firm, visit hfk.law.

Individual LLC Members Can Be Held Liable for Breach of LLC Agreement

By Jay McMillan

Members of a Delaware limited liability company (LLC) are protected from liability for debts and obligations of the LLC to third parties. 6 Del. C. §18-303. However, in a recent case, Domain Associates, L.L.C. v. Shah, C.A. No. 12921-VCL (Del. Ch. Aug. 13, 2018), Vice Chancellor Laster of the Delaware Court of Chancery held that members of an LLC who voted to terminate the membership of another member (Shah) were jointly and severally liable with the company to Shah for damages arising from their failure to pay Shah the fair value of his proportionate interest in the company.

In Domain Associates, the LLC was the management company of a venture capital firm. Shah was given a membership interest in the LLC based on his track record as an employee and his expertise in the medical devices industry. However, because of a “budgetary restructuring,” and because returns on medical device companies “severely lagged other sectors,” the other members decided that the company “no longer needed a medical devices professional.”

Shah “did not handle the news well.” He “became petulant,” asked for a written severance proposal, and “demurred or deferred” when asked for a face-to-face meeting. Eventually, the parties arrived at a “98% final draft” and agreed to let their attorneys finalize the agreement. “That would prove to be a fateful decision, because involving the lawyers caused matters to escalate.” The parties nonetheless arrived at a “handshake deal,” but when the company put the deal points in writing, Shah “rejected them out of hand and without explanation.”

The company’s operating agreement allowed for the removal of a member by the unanimous vote of all the other members. All of the members except Shah voted to remove Shah from the company. They took the position that upon his removal Shah was only entitled to the value of his capital account, $438,353.05, and not to the fair value of his membership interest. Shah contended that he was entitled to his proportionate share (12.1%) of the company’s cash on hand; his proportionate share equaled $1,553,667.

The company sued in the Delaware Court of Chancery for a determination of the amount due. The Court found that the LLC’s operating agreement did not specify what was due to a member upon a forced withdrawal. Nor did the Delaware LLC Act provide for treatment of members who withdraw involuntarily. The Court looked to Section 18-1104 of the LLC Act, which provides that in the absence of any applicable provision in the LLC Act, “the rules of law and equity … shall govern.” 6 Del. C. § 18-1104. Although the Court did not find any case law in the LLC context on point, it found that in Hillman v. Hillman, 910 A.2d 262, 271-78 (Del. Ch. 2006), then-Vice Chancellor Strine applied the analogous provision in the Delaware Limited Partnership Act, 6 Del. C. § 17-1104, to a case involving the expulsion of a limited partner. In Hillman, the Court referred in turn to Section 15-701 of the Delaware Revised Uniform Partnership Act, 6 Del. C. § 15-701, which requires that an expelled partner be paid the fair value of its economic interest in the partnership. The Court in Hillman reasoned that the same result should apply in the limited partnership context.

The Court in Domain Associates in turn reasoned that the same result should apply in the LLC context, particularly because the LLC in question was a “member-managed entity whose governance structure resembled a partnership.” The Court therefore concluded that Shah was entitled to the fair value of his proportionate interest in the LLC.

At trial, the parties presented competing experts on fair value. Shah’s expert opined that Shah’s membership interest was worth between $4.299 million and $6.067 million, while the company’s expert arrived at a fair value of $531,000. The Court adopted the company’s model, but with various changes to the inputs, most of which were favorable to Shah, and directed the parties to make the calculations. The Court also ordered that the company’s cash on hand, $12.8 million (less three months of operating expenses) should be added to its value.

Finally, the Court found, “[g]enerally speaking, a party to a contract is liable when it engages in breach. That is true for operating agreements, just as it is for other contracts.” The members of the LLC were parties to its operating agreement. They breached the agreement by failing to pay Shah the fair value of his membership interest, “while at the same time they each benefitted proportionately for the elimination of his interest.”

The members cited Section 18-303 of the Delaware LLC Act, titled “Liability to third parties,” which states that “the debts, obligations and liabilities of a limited liability company … shall be solely the debts, obligations and liabilities of the limited liability company, and no member or manager … shall be obligated personally for any such debt, obligation or liability … solely by reason of being a member or acting as a manager of the limited liability company.” The Court found, however, that Shah was not a “third party,” but rather was a member of the LLC, and the remaining members were not “passive actors,” but rather “acted by voting for Shah’s removal and then determining what positions to take regarding what Shah would be paid.” They were liable because it was their actions that resulted in breach of the operating agreement.

Domain Associates shows that although members of a Delaware LLC are not liable to third parties, they can be held liable under the Delaware LLC Act for causing breaches of the operating agreement that injure other members and benefit themselves. But given the freedom of contract inherent in the LLC form, it should be possible to draft an LLC operating agreement that would limit or eliminate that liability, for example so that a removed member would get only 50% of fair value or, if removed for cause, would get nothing but what the member originally invested. In Domain Associates, the Court made its ruling under the default provisions of the LLC Act and pertinent case law because the operating agreement did not specifically provide for payment to members who were compelled to withdraw.

James G. (Jay) McMillan is a partner in the Wilmington, Delaware office of Halloran Farkas + Kittila LLP. He concentrates his practice in complex corporate and commercial matters, with a particular focus on litigation in the Delaware Court of Chancery. For more information on the firm, visit hfk.law.

Directors, Found Not Liable as Directors, May Be Liable as Officers in Suit Brought by Sole Holdout Stockholder

By Jay McMillan

Directors of Delaware corporations cannot be held liable for breaches of the duty of care so long as their corporations’ charters include “exculpation” provisions. Those provisions, now virtually universal, protect directors from monetary damages for actions that do not involve bad faith or breaches of the duty of loyalty. In addition, corporate directors are fully protected when they rely in good faith on information, opinions, reports or statements presented by officers, employees or outside professionals, including attorneys or experts selected with reasonable care. However, neither of those protections applies under Delaware law to corporate officers, or to directors who are also officers when they are acting in their capacity as officers.

In Cirillo Family Trust v. Moezinia, C.A. No. 10116-CB (July 11, 2018), DAVA Pharmaceuticals, Inc., a private company with only 31 stockholders, was acquired by an affiliate of Endo Pharmaceuticals, Inc. All but one of DAVA’s stockholders approved the acquisition by written consent. The holdout stockholder, Cirillo, who held 0.27% of the company’s stock, brought suit against the corporation and its three directors, alleging, among other things, that the required notice to stockholders was defective under Delaware law because it omitted information that would have been material to a stockholder in deciding whether to accept the merger price or to seek appraisal of the stock in court. The notice “failed to include, among other things, any financial information relating to DAVA, any description of DAVA’s business and its future prospects, and any information about how the Merger price was determined or whether the price was fair to stockholders.”

Chancellor Andre G. Bouchard granted summary judgment in favor of the defendants on all counts. With respect to the notice, the Court found that there was no self-dealing or bad faith on the part of the director defendants, and therefore no breach of the duty of loyalty. And any breach of the directors’ duty of care was exculpated under the corporation’s certificate of incorporation and Section 102(b)(7) of the Delaware General Corporation Law. That section of the DGCL allows Delaware corporations to include provisions in their charters eliminating the liability of directors for monetary damages for breaches of their duty of care. In addition, the Court found that the director defendants were protected by Section 141(e) of the DGCL, which protects directors who rely on corporate officers, employees, attorneys, or advisors.

However, neither Section 102(b)(7) nor Section 141(e) applies to corporate officers – they apply only to directors. Thus, the plaintiff in Cirillo sought leave to amend his complaint to assert claims for breach of the duty of care against the two directors who also served as officers of DAVAS for “sending or allowing the Notice to be sent” to the plaintiff in defective form. The plaintiff pointed out that while “officers owe the same fiduciary duties to the corporation and its stockholders as directors,” they are not protected in the same way by the DGCL. Notwithstanding their status as directors, the two defendants were not protected from claims for breach of the duty of care “while acting in their capacity as officers.” Referring to Section 102(b)(7), the Court noted: “Although legislatively possible, there is currently no statutory provision authorizing comparable exculpation of corporate officers.”

The Court concluded that the plaintiff “has identified a theoretical path to recovery through a due care claim against [the two defendants] as officers where Sections 102(b)(7) and 141(e) would not apply.” The Chancellor allowed the claim to stand even though he was “highly skeptical” that the plaintiff could ultimately prevail. He stated two reasons for his ruling. First, the original claim, that the director defendants acted in bad faith in failing to include material information in the notice, had previously survived a motion to dismiss. The standard for surviving a motion to dismiss, that of stating a claim on which relief can be granted, is the same for a motion to amend a complaint. To state a claim against officers based on the same facts, the plaintiff would only have to allege that they acted with gross negligence, a lower bar than alleging bad faith for director liability. Second, the Court stated that the issue, whether the two defendants had satisfied their due care obligations with respect to the notice, had not been briefed for the Court’s consideration.

As the Court in Cirillo noted, the Delaware General Corporation Law does not protect corporate officers in the same way it protects corporate directors. In Cirillo, the defendants “relied entirely” on the corporation’s outside counsel (who was licensed only in New York) to meet the requirements of Delaware law for the form and content of the stockholder notice. Cirillo demonstrates that officers of Delaware corporations, whether or not they also act as directors, must be acutely aware of their duty of care – and of the fact that they do not have the protections as officers that are conferred on directors by the DGCL. Cirillo also brings to mind the added importance of directors’ and officers’ insurance for officers. And it reminds us that directors and officers of Delaware corporations should always seek the advice of Delaware counsel on matters of Delaware law.

James G. (Jay) McMillan is a partner in the Wilmington, Delaware office of Halloran Farkas + Kittila LLP. He concentrates his practice in complex corporate and commercial matters, with a particular focus on litigation in the Delaware Court of Chancery. For more information on the firm, visit hfk.law.