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.

Delaware Court of Chancery Awards Damages in Chevelle Case Based on Unjust Enrichment

By Jay McMillan

An unmarried couple, Kim and Terry, agreed to buy a classic muscle car, have it restored, show it, and eventually sell it for a profit. After a prolonged search, they purchased a 1970 Chevelle. Kim paid for the car, but Terry put the title in his name. Kim also paid storage and restoration costs, for a total of $66,890.47, while Terry contributed a total of only $1,200.00. After Kim caught Terry cheating on her (twice), the couple broke up. Terry claimed full ownership of the Chevelle and tried to sell it. Kim brought suit in the Delaware Court of Chancery to recover the money she spent on the car, storage and restoration, based on several different theories. Jackson v. Nocks, 2018 Del. Ch. LEXIS 130 (Apr. 24, 2018).

First, Kim argued that she and Terry formed a partnership. In Delaware, a partnership is formed through “the association of 2 or more persons (i) to carry on as co-owners a business for profit . . . whether or not the persons intend to form a partnership . . . .” Id. at *13 (quoting 6 Del. C. § 15-202(a)). An essential element of a partnership is that there must be “a common obligation to share losses as well as profits.” Id. at *14. Vice Chancellor Montgomery-Reeves concluded after trial that there was no evidence of such a common obligation. Throughout more than 150 pages of text messages, 31 pages of e-mails, and 22 pages of other documents related specifically to the Chevelle, there was no mention of an agreement to share in potential losses or to split profits. In fact, the couple discussed using the proceeds of a sale of the Chevelle to help fund Terry’s son’s college education. Because there was no common obligation to share profits and losses, the Court rejected Kim’s partnership argument.

Second, Kim argued that she should recover damages for breach of contract. She maintained that she and Terry had a legally enforceable oral agreement “(1) to co-own, restore, show, and eventually sell the Car; (2) split profits 50/50; and (3) split costs associated with the purchase and renovation 50/50.” She sought an order of specific performance of the alleged contract, which would require Terry to repay half the expenses and turn over half the profits from a sale of the Chevelle. In Delaware, “a valid contract exists when (1) the parties intended that the contract would bind them, (2) the terms of the contract are sufficiently definite, and (3) the parties exchange legal consideration.” Id. at *17-18. An intent to be bound requires that the parties to the contract assent to all material terms of the contract. Here, as with the partnership argument, the Court found that there was no agreement to be bound by the alleged terms to share profits and losses. The Court therefore rejected Kim’s contract argument.

Third, Kim argued that if there was no partnership and no contract, she should be entitled to specific performance of a promise under a theory of promissory estoppel. “To state a claim for promissory estoppel, Plaintiff must prove by clear and convincing evidence that (i) a promise was made; (ii) it was the reasonable expectation of the promisor to induce action or forbearance on the part of the promisee; (iii) the promisee reasonably relied on the promise and took action to his detriment; and (iv) such promise is binding because injustice can be avoided only by enforcement of the promise.” Id. at *22. The Court found that the first element was not present because there was no evidence that Terry had made a promise to share costs and profits. Therefore, Kim’s promissory estoppel argument was also rejected.

Fourth and finally, Kim argued that she was entitled to recover under a theory of unjust enrichment. To state a claim for unjust enrichment, a plaintiff must prove (1) that the defendant was enriched, (2) that the plaintiff was impoverished, (3) a relation between the enrichment and impoverishment, (4) the absence of justification, and (5) the absence of a remedy provided by law. Terry argued that the fourth element, the absence of justification, was not present because Kim had given him the Chevelle as a gift; therefore, his enrichment and her impoverishment were justified. This time the Court rejected Terry’s argument. Although Kim had indeed given Terry expensive gifts, including a Nissan Maxima, which he traded for a Lexus, a motorcycle, several watches, clothes, “lavish trips,” and a $200 “weekly allowance,” the evidence showed that the couple had consistently referred to the Chevelle as “ours” and “our girl.” Id. at *23. The Court found that Kim did not have “donative intent” to make a gift of the Chevelle. The Court concluded that “[f]inding for Plaintiff on the basis of unjust enrichment is the equitable remedy here,” and awarded “damages in full,” including all expenditures Kim made on the Chevelle.

Ordinarily, an action solely for money damages cannot be brought in the Court of Chancery because Delaware law provides that the Court of Chancery has jurisdiction over “matters and causes in equity” and does not have jurisdiction to determine matters where a sufficient remedy may be had in any other Delaware state court. 10 Del. C. §§ 341-42. As a court of equity (as opposed to a court of law), the Court of Chancery lacks jurisdiction over the subject matter of a case when there is a sufficient remedy at law—money damages are available in an action at law in the Delaware Superior Court or other Delaware courts.

But based on Jackson v. Nocks, where there is no partnership, no written or oral contract, and no promise made, it is still possible for an aggrieved party to get an award of money damages in the Delaware Court of Chancery based on a theory of unjust enrichment. The Court noted, however, that Terry failed to address the fifth element of an unjust enrichment claim, which is the absence of a remedy at law, and therefore the Court did not discuss it. Unjust enrichment is not in itself an equitable remedy that confers subject matter jurisdiction on the Court of Chancery. Indeed, in Crosse v. BCBSD, Inc., 836 A.2d 492, 496-97 (Del. 2003), the Delaware Supreme Court rejected the argument that an unjust enrichment claim for money damages confers equity jurisdiction on the Court of Chancery without a plea for an equitable remedy. In Jackson v. Nocks, the defendant did not contest the Court of Chancery’s subject matter jurisdiction and the Court did not raise it on its own.

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.

 

Delaware’s “Safe Harbor” for Self-Interested Transactions Is Not So Safe

By Jay McMillan

Section 144 of the Delaware General Corporation Law provides a “safe harbor” for self-interested transactions between a corporation and one or more of its directors or officers, or between a corporation and another entity in which a director or officer has a material interest. The statute provides that a transaction is not “void or voidable” solely because of such a conflict. Similar provisions sometimes appear in partnership agreements or operating agreements of limited liability companies. However, those safe harbor provisions provide little protection from claims for breach of fiduciary duty against officers and directors.

The Section 144 safe harbor applies if (1) the conflicted transaction is approved by a majority of fully informed disinterested directors, or (2) it is approved in good faith by a vote of fully informed stockholders, or (3) it is “fair as to the corporation” at the time it is approved by the board of directors, a committee of the board, or the stockholders. In Cumming v. Edens, C.A. No. 13007-VCS, mem. op. at 54-59 (Del. Ch. Feb. 20, 2018), the director defendants argued that compliance with Section 144 triggered review of a conflicted transaction under the deferential business judgment standard. They further argued that because Section 144 refers only to “disinterested” directors, the Court should not consider whether the directors approving the transaction were also independent of any interested directors. The defendants relied on Benihana of Tokyo, Inc. v. Benihana, Inc., 906 A.2d 114 (Del. 2006) (“Benihana II”), in which the Delaware Supreme Court stated that under Section 144(a)(1) “[a]fter approval by disinterested directors, courts review the interested transaction under the business judgment rule . . . .”

In Cumming, Vice Chancellor Joseph R. Slights III found that despite Benihana II, “compliance with Section 144(a)(1) does not necessarily invoke business judgment review of an interested transaction” and that common law principles still apply when determining the standard of review. The Court referred to the opinion of Vice Chancellor Parsons in Benihana of Tokyo, Inc. v. Benihana, Inc., 891 A.2d 150, 185 (Del. Ch. 2005) (“Benihana I”), aff’d, 906 A.2d 114 (Del. 2006), which was affirmed in Benihana II. In Benihana I the Court stated that compliance with Section 144 does not “always” trigger business judgment review, and that “equitable common law rules requiring the application of the entire fairness standard on grounds other than a director’s interest still apply.”

The Court in Cumming noted that before Section 144 was enacted in 1967 “a corporation’s stockholders had the right to nullify an interested transaction” and that Section 144 was enacted to prevent that “potentially harsh result.” Under Section 144, stockholders cannot void a transaction “solely” because of the presence of director self-interest. Cumming makes clear, however, that compliance with Section 144 does not provide a safe harbor against claims for breach of fiduciary duty.

An appeal of the Cumming decision based on the Delaware Supreme Court’s language in Benihana II is unlikely to succeed. The Court in Cumming also noted that in an article by Delaware Supreme Court Chief Justice Leo E. Strine, Jr. et al., the authors stated, “The question of whether section 144 was intended to create a safe harbor from equitable review… is controversial…. To date, the Delaware courts have generally read the statute more narrowly, while drawing on it in crafting rulings in equity.” On appeal, the Delaware Supreme Court is likely to read Section 144 “narrowly.”

The Court in Cumming also disagreed with the view that compliance with Section 144 shifts the burden of proving the fairness of a conflicted transaction to the plaintiff. In the respected treatise Folk on the Delaware General Corporation Law, the authors (attorneys in the Delaware office of Skadden Arps) state “[c]ompliance with Section 144 merely shifts the burden to the plaintiffs to demonstrate that the transaction was unfair.” The Court stated “[w]hile I cannot say that I share that view of our law, I need not weigh in on that issue at this stage in the proceedings.”

Having rejected the Section 144 defense, the Court in Cumming denied the defendants’ motion to dismiss for failure to state a claim, finding that the complaint adequately alleged “that the Board acted out of self-interest or with allegiance to interests other than the stockholders’.” Based on that finding, the Court applied the entire fairness standard of review and concluded that, based on the allegations of the complaint, the transaction was not fair to the corporation’s stockholders because it was not the product of “fair dealing” and did not reflect a “fair price.”

In short, a transaction that complies with Section 144 based on an informed vote of disinterested directors or stockholders will not necessarily be subject to business judgment review and will not necessarily pass entire fairness review. The Section 144 “safe harbor” is not safe from claims for breach of fiduciary duty.

Also of interest in the Cumming opinion is that the Court found that two directors were not independent based on ties to an interested director through (1) common ownership of a unique asset and (2) common board membership. In the first case, the director had been invited by the interested director, Edens, to invest with him in the Milwaukee Bucks NBA basketball franchise, an opportunity available to only 25 investors, and had assisted Edens in an effort to build a new arena for the team. Although the joint investment did not require the cooperative planning that the ownership of a private plane did in Sandys v. Pincus, the Court found that the “dynamics” of the relationship were not “any less revealing of a unique, close personal relationship.”

In the second case the director in question also served with Edens on the board of another company, both of which were managed by Fortress, a company of which Edens was a principal. Fortress was the parent company of the counter-party to the challenged transaction. The director was placed on both boards by Fortress and derived 60% of his publicly reported income from Fortress-managed companies. He also listed Fortress as his forwarding address on public filings for unrelated investments. The Court concluded that the director lacked independence because of his “material ties” to Edens and Fortress.

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.

Delaware Supreme Court Affirms Dismissal of Wal-Mart Case

By Jay McMillan

In California State Teachers’ Retirement System v. Alvarez, 2018 Del. LEXIS 41 (Del. Jan. 25, 2018), the Delaware Supreme Court affirmed the Court of Chancery’s dismissal of a derivative suit against the board of directors of Wal-Mart Stores, Inc., finding that the claims were precluded because a similar suit in an Arkansas federal court had been dismissed for the stockholder plaintiffs’ failure to make a demand for action on the board, or to plead that such a demand would be futile. The Court found that the Arkansas plaintiffs’ representation of the corporation’s stockholders was not “grossly deficient” despite their failure to make a demand for inspection of corporate books and records under Section 220 of the Delaware General Corporation Law. The Court also rejected Chancellor Andre G. Bouchard’s recommendation that it adopt a more plaintiff-friendly standard.

The Delaware and Arkansas suits both asserted claims for breach of fiduciary duty against Wal-Mart’s directors for failure to adequately oversee the company’s Mexican unit, Wal-Mart de Mexico (WalMex), whose executives allegedly engaged in a bribery scheme and cover-up. Following an April 2012 report in the New York Times, eight derivative complaints were filed in the United States District Court for the Western District of Arkansas, and seven more were filed in the Delaware Court of Chancery. The Arkansas court initially stayed its proceedings pending the Delaware action. At the urging of then-Chancellor Leo Strine, the Delaware plaintiffs sought Wal-Mart’s books and records under Section 220. However, the “unusually contentious” Section 220 action dragged on for three years.

Meanwhile, in 2013, the Arkansas court’s stay was lifted and, on March 31, 2015, the Arkansas court granted the director defendants’ motion to dismiss with prejudice for the plaintiffs’ failure to make demand or plead demand futility as required by Rule 23.1 of the Federal Rules of Civil Procedure. One month later, on May 1, 2015, the Delaware plaintiffs amended their complaint based on what they had learned from Wal-Mart’s books and records. The director defendants moved to dismiss the amended complaint based on res judicata, or issue preclusion, arguing that the Delaware plaintiffs were precluded by the Arkansas dismissal from pleading that demand was excused as futile.

Chancellor Bouchard granted the motion to dismiss based on res judicata. The stockholder plaintiffs appealed to the Delaware Supreme Court, arguing, among other things, that they were denied their federal right of due process. The Delaware Supreme Court affirmed the dismissal, finding that the issues were the same in both actions and that the plaintiffs in the two actions were “in privity,” or had identical interests, because, under applicable Arkansas law and federal law, the real party in interest in both cases was the corporation.

Chancellor Bouchard’s recommendation that the Delaware Supreme Court should establish a more plaintiff-friendly standard was rejected. In a supplemental opinion issued on remand, Chancellor Bouchard suggested that res judicata should not apply where an action in another jurisdiction was dismissed for failure to make demand. The Chancellor recommended that the Delaware Supreme Court adopt a rule proposed by Vice Chancellor J. Travis Laster in In re EZCORP Inc. Consulting Agreement Derivative Litigation, 130 A.3d 934 (Del. Ch. 2016), which would allow other representative plaintiffs to assert derivative claims after an action was dismissed under Rule 23.1. The Chancellor suggested that such a rule would “better safeguard the due process rights of stockholder plaintiffs and should go a long way to addressing fast-filer problems currently inherent in multi-forum derivative litigation.”

The Delaware Supreme Court disagreed, finding that all three federal circuit courts of appeal that addressed the issue held that stockholder plaintiffs’ due process rights were protected “when their interests were aligned with and were adequately represented by the prior plaintiffs,” and that “most other cases” granted preclusive effect to prior Rule 23.1 dismissals.

The Delaware Supreme Court found that the Arkansas plaintiffs and the Delaware plaintiffs had an identity of interests, that they were both aware that a judgment in one case could have a preclusive effect on the other case, and that the Arkansas stockholder plaintiffs adequately represented the Delaware stockholder plaintiffs. As to adequacy of representation, the Delaware Supreme Court found that “(i) the quality of their representation was not grossly deficient, and (ii) their economic interests were not antagonistic to other stockholders.” The Court found that the Arkansas plaintiffs decided not to make a Section 220 demand – as urged by then-Chancellor Strine – because they thought that documents in the public domain cited in the New York Times article were sufficient to plead demand futility. Although that turned out to be a “tactical error,” the decision not to make a Section 220 demand “in this instance does not rise to the level of constitutional inadequacy.” (Emphasis in original).

The Delaware Supreme Court thus left open the possibility that failure to make a Section 220 demand could in another instance make a plaintiff an inadequate representative, which would allow a subsequent plaintiff to proceed without preclusion. The Court agreed, however, with the Court of Chancery’s conclusion that “it does not follow that plaintiffs are necessarily inadequate representatives because their counsel chose not to follow a recommended strategy in a different action, even one suggested by a preeminent corporate jurist, particularly when they are litigating in a different jurisdiction before a different judiciary.” The Arkansas plaintiffs were not inadequate representatives merely because they failed to make a Section 220 demand or because they subsequently failed to adequately plead demand futility.

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.