In What State Is the Harm Felt When a Derivative Suit Is Pursued By Creditors?

The trustee sued Mahalo Canada's D&Os. Mahalo USA was a wholly owned subsidiary of Mahalo Canada. Mahalo USA was a Delaware corporation operating exclusively in Oklahoma, while Mahalo Canada was incorporated and operated in Alberta. All defendants were citizens of Alberta.

The suit alleged breaches of fiduciary duty against directors of Mahalo Canada, some of whom also were D&Os of Mahalo USA. The opinion never explores whether the “overlapping” directors could have been subject to jurisdiction on the ground that they were D&Os of the debtor itself. See, e.g., 10 Del. C. ' 3114 (directors of a Delaware Corporation consent to jurisdiction in Delaware for claims against them in their capacity as directors). Instead, it focuses on these individuals' roles as directors of the Canadian parent.

The suit's gravamen was as follows. Mahalo Canada allegedly acquired another company, assumed its debt, and transferred the debt to Mahalo USA while keeping the equity at Mahalo Canada. It also encumbered Mahalo USA's assets as security for Mahalo Canada's $50M line of credit. Then Mahalo Canada sold some of its assets to an investment vehicle in which most of the defendants had invested, which made Mahalo USA's assets the primary security for Mahalo Canada's line of credit. Finally, Mahalo Canada allegedly caused Mahalo USA to pay off the entirety of Mahalo Canada's line of credit and enter into a new $105M line of credit, upon which Mahalo USA quickly defaulted. The individual defendants allegedly caused these actions to further their own profits, at the expense of Mahalo USA and its creditors.

The Court's Holding

To determine whether the assertion of personal jurisdiction over these Canadian citizens was constitutionally permissible, the court started with the proposition that the defendants were not alleged to have “continuous and systematic general business contacts with the forum state” sufficient to support general personal jurisdiction. Id. at 1264 (citation omitted). Thus, specific personal jurisdiction ' i.e., jurisdiction specific to the dispute ' is necessary to support a finding of minimum contacts. That, in turn, requires an analysis of whether the defendants have purposefully directed their activities at the forum state. For tort claims, the “purposeful availment” test has three factors: “(a) an intentional act ' that was (b) expressly aimed at the forum state ' with (c) knowledge that the brunt of the injury would be felt in the forum state.” Id. at 1265 (citation omitted).

Here, the key to applying that test was understanding the nature of, as the court put it, “who was injured, and where?” Id. at 1257, 1261, 1267, 1268. And that is where the opinion gets controversial.

Citing Gheewalla, 930 A.2d at 101-03, the court stated that upon insolvency, “the director ' owes fiduciary duties to the creditors as well as the corporation.” Newsome, 722 F.3d at 12667. The court stated that under Gheewalla, creditors can “almost never bring a direct action for breach of fiduciary duty,” id., due to policy concerns ' directors must not be said to owe fiduciary duties to creditors because they must retain their ability to negotiate rigorously with creditors. (It should be noted that “almost never” is not what the Delaware Supreme Court stated in Gheewalla; it specifically held that creditors “have no right to assert direct claims,” overruling Production Res. Group, LLC v. NCT Group, Inc., 863 A. 2d 772 (Del. Ch. 2004), which had left open such a possibility.

Since creditors cannot bring direct claims, the court acknowledged that the following questions exist: “if Newsome is not considered to be asserting the creditors' claims, but rather Mahalo USA's claims, then where was Mahalo USA injured? And may we nonetheless consider injury to and location of Mahalo USA's creditors when evaluating personal jurisdiction?” Newsome, 722 F.3d at 1267. In other words, the court grappled with whether it could consider where the creditors were harmed in determining where the tort took place under the purposeful availment test, even though the claim did not belong to the creditors, but rather to Mahalo USA itself.

It held that the answer is yes. Essentially treating the concept of a derivative claim as procedural, it stated that:

when Delaware courts say that the injured party is the corporation principally, and the creditors only derivatively, these courts are really responding to the question of when and how creditors may sue for those injuries. Thus, to say “this is the corporation's injury,” does not mean that the creditors have suffered no harm, just that the creditors may not sue directly for that harm.

Id. at * 1268.

Accordingly, the court held that “we do not believe due process requires us to ignore where the injury was actually felt, even if those who felt it face some impediment to suit on account of substantive corporate law.” Id. Rather, “a court evaluating personal jurisdiction need not ignore the creditors' or shareholders' place of residence simply because the cause of action belongs to the corporation.” Id.

Because most of the creditors were Oklahoma residents, the court concluded that the harm occurred in Oklahoma under the purposeful availment test. Therefore, the Canadian residents were subject to jurisdiction in Oklahoma.

'Analysis

In the author's view, the court was mistaken in holding that the harm to the corporation occurred where the creditors were harmed. Delaware law on derivative claims is not merely procedural, limiting the technicalities of how creditors or stockholder may sue. Rather, it is substantive law. See, e.g., Rales v. Blasband, 634 A.2d 927, 932 (Del. 1993) (“The stockholder derivative suit is an important and unique feature of corporate governance.”) The concept is that the company itself is harmed, and therefore any recovery in the suit belongs to the corporation. See Tooley v. Donaldson, Lufkin & Jenrette, Inc., 845 A.2d 1031, 1036 (Del. 2004) (“Because a derivative suit is being brought on behalf of the corporation, the recovery, if any, must go to the corporation.”).

That is why the suit is described as the company's property. See, e.g., Rales, 634 A.2d at 932 (“In [a derivative] suit, a stockholder asserts a cause of action belonging to the corporation.”). Accordingly, it is no mere technicality of “when and how creditors may sue for those injuries,” as the Newsome court stated. Indeed, Newsome's thematic question of “who was injured” is emphatically answered by settled Delaware law involving derivative claims: One of the only two questions that must be answered in determining whether a claim is direct or derivative is “who suffered the alleged harm (the corporation or the suing stockholders, individually).” Tooley, 845 A.2d at 1033.

In a derivative suit, the residual stakeholders, who indirectly benefit from an increase in corporate value, are those afforded standing to prosecute the corporation's claim if they follow the right steps ' shareholders of a solvent corporation, or creditors of an insolvent corporation. See Gheewalla, 930A.2d at 92. But the fact that a person may obtain standing to prosecute the corporation's claims in no way suggests that any harm to that person is relevant to any aspect of the case. See Tooley, 845 A.2d at 1036 (a direct “claim is distinct from an injury caused to the corporation itself.”).

Indeed, the very concept is that all such stakeholders experienced the same harm, secondarily ' a loss in company value. See, e.g., Gheewalla, 930 A.2d at 102 (derivative claims “belong to the corporation itself because even if the improper acts occur when the firm is insolvent, they operate to injure the firm in the first instance by reducing its value, injuring creditors only indirectly by diminishing the value of the firm and therefore the assets from which the creditors may satisfy their claims.”) (quoting Production Res., 863 A.2d at 776).

In short, the fact that a creditor has suffered harm ought to be irrelevant because the purposeful availment test measures specific jurisdiction, and harm to creditors individually is an entirely different claim than one asserted in a derivative suit, which solely looks to the harm suffered by the corporation.

The analysis in Newsome is even more attenuated because the suit was not a derivative suit, but rather a direct suit filed by the company's representative ' a trustee appointed pursuant to a plan. The trustee was vested only with the corporation's own claims, not the claims belonging to creditors. Newsome, 722 F3d at 1266. To the extent that creditors also were individually harmed, that harm would result in a separate set of claims which the trustee does not have the power to bring. Trenwick Am. Litig. Trust v. Ernst & Young, L.L.P., 906 A.2d 168, 191 (Del. Ch. 2006), aff'd sub nom. Trenwick Am. Litig. Trust v. Billett, 931 A.2d 438 (Del. 2007) (“federal bankruptcy law is clear that litigation trusts do not have standing to pursue the direct claims of creditors”); In re World Health Alternatives, Inc., 385 B.R. 576, 595 (Bankr. D. Del. 2008) (“a bankruptcy trustee does not have standing to assert claims on behalf of an estate's creditors”). It is difficult to see how harms alleged from those separate claims, which the trustee may not even pursue, could matter for the purposes of personal jurisdiction over the claims the trustee is empowered to prosecute. After all, the purposeful availment test is a test of specific personal jurisdiction, not general personal jurisdiction.

The lynchpin of the court's analysis might well be its misperception of Gheewalla. The court stated that “in a lawsuit claiming breach of fiduciary duty, we believe it is appropriate to consider harm to those to whom a fiduciary duty was owed ' in this case, the creditors ' when answering the question of who was injured and where.” Newsome, 722 F.3d at 1268. But Ghewalla does not hold that creditors are owed fiduciary duties when the company is insolvent. Rather, Gheewalla holds that upon actual insolvency, directors owe fiduciary duties to the corporation itself. Ghewalla, 930 A.2d at 101.

The Delaware Supreme Court certainly recognized that upon insolvency, what is in the best interests of the corporation often departs from what is in the best interests of stockholders, and noted that creditors at that point are the residual beneficiaries of any increase in value. Id. But it never said that duties shift to creditors; instead, it held only that the directors' duty is “to maximize the value of the insolvent corporation for the benefit of all those having an interest in it” ' whether creditors or stockholders. Id. at 103. While a breach of that duty may be enforced by a creditor with derivative standing, there is no duty owed directly to creditors. Id. (“individual creditors of an insolvent corporation have no right to assert direct claims for breach of fiduciary duty against corporate directors.”).

Thus, it is neither proper to consider the creditors' individual harm to be harm felt by the corporation, nor to consider the harm felt individually by creditors on the basis that fiduciary duties are owed to creditors. The first concept considers the wrong claim, and the second is simply an inaccurate statement of Delaware law.

Moreover, the Tenth Circuit's analysis is not one that the state whose substantive law applies ' Delaware ' has ever entertained. After research, we located no Delaware case, ruling on an objection to personal jurisdiction in a derivative suit, that rests its opinion on (or even considers) where the stockholders or creditors are located. That is simply not a factor that a Delaware court has ever held to be germane. Perhaps the reason for this is practical: The Newsome case apparently was very unusual in that nearly all of the creditors were Oklahoma residents. In a typical derivative case, stockholders or creditors might be located in many states. Newsome does not analyze whether the purposeful availment test would have been met if, for example, 30% of the creditors were located in Oklahoma ' or whether, if creditors are located and “harmed” in 40 states, the Canadian defendants would have been subject to jurisdiction in 40 states.

Practical Advice

It is not clear whether other courts will follow the Tenth Circuit on this issue. If faced with such a case, defendants should argue that Newsome should not be followed because fiduciary duties are not owed to creditors under Delaware law, the harm to a creditor is separate to the harm felt directly by the company, and in general the defendants did not avail themselves purposefully with the forum state. The plaintiffs, in contrast, should consider placing more emphasis on the fact that the “overlapping” directors and officers ' i.e., those who were directors of Mahalo USA as well as Mahalo Canada ' already had subjected themselves to jurisdiction within the United States in their role as D&Os of Mahalo USA. Moreover, in attempting to state a reasoned basis for arguing that the harm to the company occurred in the forum state, the plaintiff should focus on whether the forum state was the state of the company's principal place of business, as was the case in Newsome, or where it was incorporated, because it is logical to believe that the company is harmed where the company itself is located or incorporated.

Russell C. Silberglied, a member of this newsletter's Board of Editors, is a director at Richards, Layton & Finger, P.A. in Wilmington, DE. He can be reached at [email protected]. The views expressed in this article are those of the author and not necessarily of RL&F or its clients.

Can a trustee of a litigation trust created under a plan sue in a U.S. bankruptcy court the directors and officers of a non-debtor Canadian parent, when many of the defendant D&Os had rarely set foot in the forum state? According to a recent Tenth Circuit opinion, the answer is yes. Newsome v. Gallacher , 722 F.3d 1257, (10th Cir. 2013). This might surprise directors and officers of Canadian parent companies. As explained below, the holding might be explained, in part, by a misreading of the Delaware Supreme Court's holding in North Am. Catholic Educ. Programming Found. v. Gheewalla , 930 A.2d 92 (Del. 2007).

Background

The plaintiff was a litigation trustee. While the opinion does not specifically so state, it appears that he was appointed pursuant to a confirmed plan of Mahalo Energy USA. The court states that the bankruptcy court appointed the trustee “to administer the legal claims of Mahalo Energy (USA).” Newsome, 722 F.3d at 1262. It also notes that “The bankruptcy court ' gave Newsome charge over Mahalo USA's legal claims, instructing him to administer them 'for the benefit of creditors.'” Id. at 1266.

The trustee sued Mahalo Canada's D&Os. Mahalo USA was a wholly owned subsidiary of Mahalo Canada. Mahalo USA was a Delaware corporation operating exclusively in Oklahoma, while Mahalo Canada was incorporated and operated in Alberta. All defendants were citizens of Alberta.

The suit alleged breaches of fiduciary duty against directors of Mahalo Canada, some of whom also were D&Os of Mahalo USA. The opinion never explores whether the “overlapping” directors could have been subject to jurisdiction on the ground that they were D&Os of the debtor itself. See, e.g., 10 Del. C. ' 3114 (directors of a Delaware Corporation consent to jurisdiction in Delaware for claims against them in their capacity as directors). Instead, it focuses on these individuals' roles as directors of the Canadian parent.

The suit's gravamen was as follows. Mahalo Canada allegedly acquired another company, assumed its debt, and transferred the debt to Mahalo USA while keeping the equity at Mahalo Canada. It also encumbered Mahalo USA's assets as security for Mahalo Canada's $50M line of credit. Then Mahalo Canada sold some of its assets to an investment vehicle in which most of the defendants had invested, which made Mahalo USA's assets the primary security for Mahalo Canada's line of credit. Finally, Mahalo Canada allegedly caused Mahalo USA to pay off the entirety of Mahalo Canada's line of credit and enter into a new $105M line of credit, upon which Mahalo USA quickly defaulted. The individual defendants allegedly caused these actions to further their own profits, at the expense of Mahalo USA and its creditors.

The Court's Holding

To determine whether the assertion of personal jurisdiction over these Canadian citizens was constitutionally permissible, the court started with the proposition that the defendants were not alleged to have “continuous and systematic general business contacts with the forum state” sufficient to support general personal jurisdiction. Id. at 1264 (citation omitted). Thus, specific personal jurisdiction ' i.e., jurisdiction specific to the dispute ' is necessary to support a finding of minimum contacts. That, in turn, requires an analysis of whether the defendants have purposefully directed their activities at the forum state. For tort claims, the “purposeful availment” test has three factors: “(a) an intentional act ' that was (b) expressly aimed at the forum state ' with (c) knowledge that the brunt of the injury would be felt in the forum state.” Id. at 1265 (citation omitted).

Here, the key to applying that test was understanding the nature of, as the court put it, “who was injured, and where?” Id. at 1257, 1261, 1267, 1268. And that is where the opinion gets controversial.

Citing Gheewalla, 930 A.2d at 101-03, the court stated that upon insolvency, “the director ' owes fiduciary duties to the creditors as well as the corporation.” Newsome, 722 F.3d at 12667. The court stated that under Gheewalla , creditors can “almost never bring a direct action for breach of fiduciary duty,” id ., due to policy concerns ' directors must not be said to owe fiduciary duties to creditors because they must retain their ability to negotiate rigorously with creditors. (It should be noted that “almost never” is not what the Delaware Supreme Court stated in Gheewalla ; it specifically held that creditors “have no right to assert direct claims,” overruling Production Res. Group, LLC v. NCT Group, Inc. , 863 A. 2d 772 (Del. Ch. 2004), which had left open such a possibility.

Since creditors cannot bring direct claims, the court acknowledged that the following questions exist: “if Newsome is not considered to be asserting the creditors' claims, but rather Mahalo USA's claims, then where was Mahalo USA injured? And may we nonetheless consider injury to and location of Mahalo USA's creditors when evaluating personal jurisdiction?” Newsome, 722 F.3d at 1267. In other words, the court grappled with whether it could consider where the creditors were harmed in determining where the tort took place under the purposeful availment test, even though the claim did not belong to the creditors, but rather to Mahalo USA itself.

It held that the answer is yes. Essentially treating the concept of a derivative claim as procedural, it stated that:

when Delaware courts say that the injured party is the corporation principally, and the creditors only derivatively, these courts are really responding to the question of when and how creditors may sue for those injuries. Thus, to say “this is the corporation's injury,” does not mean that the creditors have suffered no harm, just that the creditors may not sue directly for that harm.

Id. at * 1268.

Accordingly, the court held that “we do not believe due process requires us to ignore where the injury was actually felt, even if those who felt it face some impediment to suit on account of substantive corporate law.” Id. Rather, “a court evaluating personal jurisdiction need not ignore the creditors' or shareholders' place of residence simply because the cause of action belongs to the corporation.” Id.

Because most of the creditors were Oklahoma residents, the court concluded that the harm occurred in Oklahoma under the purposeful availment test. Therefore, the Canadian residents were subject to jurisdiction in Oklahoma.

'Analysis

In the author's view, the court was mistaken in holding that the harm to the corporation occurred where the creditors were harmed. Delaware law on derivative claims is not merely procedural, limiting the technicalities of how creditors or stockholder may sue. Rather, it is substantive law. See, e.g., Rales v. Blasband , 634 A.2d 927, 932 (Del. 1993) (“The stockholder derivative suit is an important and unique feature of corporate governance.”) The concept is that the company itself is harmed, and therefore any recovery in the suit belongs to the corporation. See Tooley v. Donaldson, Lufkin & Jenrette, Inc. , 845 A.2d 1031, 1036 (Del. 2004) (“Because a derivative suit is being brought on behalf of the corporation, the recovery, if any, must go to the corporation.”).

That is why the suit is described as the company's property. See, e.g., Rales, 634 A.2d at 932 (“In [a derivative] suit, a stockholder asserts a cause of action belonging to the corporation.”). Accordingly, it is no mere technicality of “when and how creditors may sue for those injuries,” as the Newsome court stated. Indeed, Newsome's thematic question of “who was injured” is emphatically answered by settled Delaware law involving derivative claims: One of the only two questions that must be answered in determining whether a claim is direct or derivative is “who suffered the alleged harm (the corporation or the suing stockholders, individually).” Tooley, 845 A.2d at 1033.

In a derivative suit, the residual stakeholders, who indirectly benefit from an increase in corporate value, are those afforded standing to prosecute the corporation's claim if they follow the right steps ' shareholders of a solvent corporation, or creditors of an insolvent corporation. See Gheewalla, 930A.2d at 92. But the fact that a person may obtain standing to prosecute the corporation's claims in no way suggests that any harm to that person is relevant to any aspect of the case. See Tooley, 845 A.2d at 1036 (a direct “claim is distinct from an injury caused to the corporation itself.”).

Indeed, the very concept is that all such stakeholders experienced the same harm, secondarily ' a loss in company value. See, e.g., Gheewalla, 930 A.2d at 102 (derivative claims “belong to the corporation itself because even if the improper acts occur when the firm is insolvent, they operate to injure the firm in the first instance by reducing its value, injuring creditors only indirectly by diminishing the value of the firm and therefore the assets from which the creditors may satisfy their claims.”) (quoting Production Res., 863 A.2d at 776).

In short, the fact that a creditor has suffered harm ought to be irrelevant because the purposeful availment test measures specific jurisdiction, and harm to creditors individually is an entirely different claim than one asserted in a derivative suit, which solely looks to the harm suffered by the corporation.

The analysis in Newsome is even more attenuated because the suit was not a derivative suit, but rather a direct suit filed by the company's representative ' a trustee appointed pursuant to a plan. The trustee was vested only with the corporation's own claims, not the claims belonging to creditors. Newsome, 722 F3d at 1266. To the extent that creditors also were individually harmed, that harm would result in a separate set of claims which the trustee does not have the power to bring. Trenwick Am. Litig. Trust v. Ernst & Young, L.L.P. , 906 A.2d 168, 191 (Del. Ch. 2006), aff'd sub nom. Trenwick Am. Litig. Trust v. Billett , 931 A.2d 438 (Del. 2007) (“federal bankruptcy law is clear that litigation trusts do not have standing to pursue the direct claims of creditors”); In re World Health Alternatives, Inc., 385 B.R. 576, 595 (Bankr. D. Del. 2008) (“a bankruptcy trustee does not have standing to assert claims on behalf of an estate's creditors”). It is difficult to see how harms alleged from those separate claims, which the trustee may not even pursue, could matter for the purposes of personal jurisdiction over the claims the trustee is empowered to prosecute. After all, the purposeful availment test is a test of specific personal jurisdiction, not general personal jurisdiction.

The lynchpin of the court's analysis might well be its misperception of Gheewalla. The court stated that “in a lawsuit claiming breach of fiduciary duty, we believe it is appropriate to consider harm to those to whom a fiduciary duty was owed ' in this case, the creditors ' when answering the question of who was injured and where.” Newsome, 722 F.3d at 1268. But Ghewalla does not hold that creditors are owed fiduciary duties when the company is insolvent. Rather, Gheewalla holds that upon actual insolvency, directors owe fiduciary duties to the corporation itself. Ghewalla, 930 A.2d at 101.

The Delaware Supreme Court certainly recognized that upon insolvency, what is in the best interests of the corporation often departs from what is in the best interests of stockholders, and noted that creditors at that point are the residual beneficiaries of any increase in value. Id. But it never said that duties shift to creditors; instead, it held only that the directors' duty is “to maximize the value of the insolvent corporation for the benefit of all those having an interest in it” ' whether creditors or stockholders. Id. at 103. While a breach of that duty may be enforced by a creditor with derivative standing, there is no duty owed directly to creditors. Id. (“individual creditors of an insolvent corporation have no right to assert direct claims for breach of fiduciary duty against corporate directors.”).

Thus, it is neither proper to consider the creditors' individual harm to be harm felt by the corporation, nor to consider the harm felt individually by creditors on the basis that fiduciary duties are owed to creditors. The first concept considers the wrong claim, and the second is simply an inaccurate statement of Delaware law.

Moreover, the Tenth Circuit's analysis is not one that the state whose substantive law applies ' Delaware ' has ever entertained. After research, we located no Delaware case, ruling on an objection to personal jurisdiction in a derivative suit, that rests its opinion on (or even considers) where the stockholders or creditors are located. That is simply not a factor that a Delaware court has ever held to be germane. Perhaps the reason for this is practical: The Newsome case apparently was very unusual in that nearly all of the creditors were Oklahoma residents. In a typical derivative case, stockholders or creditors might be located in many states. Newsome does not analyze whether the purposeful availment test would have been met if, for example, 30% of the creditors were located in Oklahoma ' or whether, if creditors are located and “harmed” in 40 states, the Canadian defendants would have been subject to jurisdiction in 40 states.

Practical Advice

It is not clear whether other courts will follow the Tenth Circuit on this issue. If faced with such a case, defendants should argue that Newsome should not be followed because fiduciary duties are not owed to creditors under Delaware law, the harm to a creditor is separate to the harm felt directly by the company, and in general the defendants did not avail themselves purposefully with the forum state. The plaintiffs, in contrast, should consider placing more emphasis on the fact that the “overlapping” directors and officers ' i.e., those who were directors of Mahalo USA as well as Mahalo Canada ' already had subjected themselves to jurisdiction within the United States in their role as D&Os of Mahalo USA. Moreover, in attempting to state a reasoned basis for arguing that the harm to the company occurred in the forum state, the plaintiff should focus on whether the forum state was the state of the company's principal place of business, as was the case in Newsome, or where it was incorporated, because it is logical to believe that the company is harmed where the company itself is located or incorporated.

Russell C. Silberglied, a member of this newsletter's Board of Editors, is a director at Richards, Layton & Finger, P.A. in Wilmington, DE. He can be reached at [email protected]. The views expressed in this article are those of the author and not necessarily of RL&F or its clients.