DE Corporate Law and Chancery Review

Three recent decisions from the Delaware Court of Chancery provide useful legal insights for corporate executives and those who counsel them. The first case deals with the requirements that must be satisfied before a stockholder or part owner of a company is able to sue based on a claim of excessive compensation. The second case describes the requirements that need to be satisfied if a stockholder seeks records of the company. The last case addresses the attempt of a creditor to pursue a claim for breach of fiduciary duty.

Chancery Rejects Derivative Claim Against LLC

A recent Court of Chancery opinion is notable as a reminder that the same requirement of pre-suit demand futility in the corporate context is also required to be satisfied as a prerequisite to asserting a derivative claim in the LLC context. Dietrichson v. Knott, C.A. No. 11965-VCMR (Del. Ch. April 19, 2017).

Background

This matter involved two 50/50 members of an LLC. One of those members filed claims alleging that an unauthorized salary was taken by the other member, and that the other member misappropriated the proceeds of an asset sale.

Key Takeaways

The court explained that the claims regarding improper compensation and misappropriation of company assets were derivative in nature based on the criteria described in the Delaware Supreme Court's Tooley decision, and that because pre-suit demand futility was not established, the claims were dismissed. The court also referred to Section 18-1001 of the Delaware LLC Act and Chancery Rule 23.1 for the requirements of pre-suit demand applicable in the LLC context.

The court reasoned that the claims of excessive compensation and dissipation of company assets are inherently derivative, and the facts of this case did not allow them to qualify as “dual-natured.” Only in exceptional circumstances can a claim be both direct and derivative.

In addition to dismissing the claims for failure to satisfy the prerequisites of derivative claims, the court dismissed an unjust enrichment claim based on the well-known principle that when a complaint alleges an express, enforceable contract that controls the parties' relationship, a claim for unjust enrichment will be dismissed.

Chancery Grants Section 220 Demand

The Court of Chancery issued an important decision for those who need to understand the latest nuances of Delaware law involving DGCL Section 220, which allows a stockholder to demand corporate records. Over the last 12 years, there have been a plethora of rulings supporting the view that demands pursuant to Section 220 are not for the faint of heart. Rumors of the death of Section 220, however, have been greatly exaggerated, in light of the ruling in Rodgers v. Cypress Semiconductor Corporation, C.A. No. 2017-0070-AGB (Del. Ch. April 17, 2017).

Background

A former CEO of the company involved in this case sought books and records to investigate allegedly excessive compensation paid to the executive chairman of the board, and also alleged that the chairman violated the Code of Business Conduct and Ethics of the company. The company defended the claim based on the argument that the former CEO's stated purpose was not the true purpose, and that the true purpose for the request was not proper. The company also denied the Section 220 demand based on the argument that there were no claims for non-exculpated allegations.

Key Takeaways

The most noteworthy aspects of this opinion are the following:

• The court explained that there remains a very high threshold to establish that the “true improper main purpose” of a demand is something other than the stated primary purpose.
• The court recited the prerequisites for a demand under Section 220, such as having a proper purpose and having a credible basis for claims to support the purpose to investigate wrongdoing. In this post-trial opinion, the court found the testimony of the claimant credible that his primary purpose was proper. Those primary purposes included investigation of wrongdoing such as a conflict of interest in violation of the company's Code of Business Conduct and Ethics, as well as a desire to communicate with other stockholders and attempt to persuade the board to make changes.
• The court distinguished the decision of the Delaware Supreme Court in Southeastern Pennsylvania Transportation Authority v. AbbVie. Specifically, AbbVie stands for the position that when the sole purpose for a Section 220 demand is to investigate wrongdoing of an exculpated claim, a Section 220 demand will be denied. By contrast, in this matter, derivative litigation to pursue claims of an exculpated nature were not the sole motivation to investigate wrongdoing. The other proper purposes included communication with stockholders and evaluation of suitability of members of the board to continue to serve.
• The court rejected the argument that the true purpose of the Section 220 demand in this matter was to pursue a personal vendetta and to assist in an ongoing proxy battle by the claimant. The court cited to cases finding that it is a high hurdle to prevail on an argument that the primary purpose, contrary to the stated purpose of a claimant, is personal animosity or other improper motives.
• The court described the importance of a confidentiality agreement to limit the use of the documents obtained, to minimize the risk that the data would be used for purposes of a proxy contest, although application to the court could be made for seeking approval to use the information for other purposes in the future.

Chancery: Creditor Has No Standing to Sue LLC Derivatively

The Delaware Court of Chancery recently addressed the attempts of a creditor to sue the controlling members of an LLC for breach of fiduciary duty and related claims in connection with allegations that those members deceived the creditor into lending money on false pretenses. In Trusa v. Nepo, C.A. No. 12071-VCMR (Del. Ch. April 13, 2017), the court determined that the creditor had no standing for such claims — nor did a power of attorney provide a basis for standing.

Background

The creditor involved in this matter was verbally seduced into making an investment in the LLC, and was led to believe that his investments would be secured. One of the provisions in the loan documents was a power of attorney that allowed for certain default remedies. After the LLC defaulted on the loans, the creditor learned of various dishonest dealings and misrepresentations regarding the status of the company and what the funds were used for.

Before the Chancery suit was filed, a complaint was filed in the Delaware Superior Court and a default judgment was entered. This Chancery suit was brought claiming that the managing members breached their fiduciary duties. The creditor also sought a dissolution of the LLC in addition to asserting fraud and related claims.

Key Legal Principles

The most noteworthy aspect of this decision is the court's holding that a creditor has no standing to bring derivative claims on behalf of an LLC for breach of fiduciary duty, based primarily on Section 18-1002 of the Delaware LLC Act. Together with Section 18-1001 of the Act, it remains unambiguous that only members and assignees can assert derivative claims on behalf of an LLC. Prior opinions by Chancery and the Delaware Supreme Court endorsed the foregoing interpretation of the Act. See CML V, LLC v. Bax (Bax I) 6 A.3d 238 Del. Ch. 2010) aff'd CML V, LLC v. Bax (Bax II), 28 A.3d 1037, 1043 (Del. 2011). See also In Re Carlisle Etcetera LLC, 114 A. 3d 592, 604 (Del. Ch. 2015) (explaining that although they are barred from derivative actions, creditors have adequate remedies at law to protect their interests such as liens on assets. This case also addresses equitable dissolution.)

The court also explained that the creditor's power of attorney does not and cannot provide standing that is otherwise denied for the derivative claims attempted by him. The court observed that such a contrary argument ignores the fact that the power of attorney is expressly limited to pursuing remedies provided in the loan agreement.

No Standing for Dissolution Either

Regarding the dissolution claims, Section 18-802 of the Act limits a request for dissolution of an LLC to either a member or a manager. The creditor in this case likewise failed to establish standing for his request for dissolution. Section 18-203(a) of the Act provides seven ways that a certificate of cancellation of an LLC may be filed. The ability to file such a certificate did not help this creditor because only after dissolution and winding up of an LLC may a creditor seek appointment of a trustee or a receiver in connection with a prior dissolution.

Regarding the extreme remedy of “equitable dissolution,” the court found insufficient facts in the record to justify such an exercise of the court's authority.

Fraud Claim Fails

The court emphasized the truism that a simple breach of contract cannot be bootstrapped into a fraud claim. For example, the court quoted from prior case law holding that: “a party's failure to keep a promise does not prove the promise was false when made, and that the plaintiff did not adduce evidence showing that the defendant intended to renege as of the time it made the promise.”

Material Omission

The court found that the claim that a material omission amounted to fraud was not adequately alleged for several reasons. The court explained that in an arm's-length negotiation: “where no special relationship between the parties exists, a party has no affirmative duty to speak and is under no duty to disclose facts of which he knows the other is ignorant even if he further knows the other, if he knew of them, would regard them as material in determining his course of action in the transaction in question.”

The court further reasoned that a fraud claim cannot start from an omission in an arm's-length setting. Rather, if a party chooses to speak, then he cannot lie, and “once the party speaks, it also cannot do so partially or obliquely such that what the party conveys becomes misleading.”

*****
Francis G.X. Pileggi is a Member-in-Charge of the Wilmington office of Eckert Seamans Cherin & Mellott. His litigation practice emphasizes representation in high-stakes disputes of corporations, stockholders, members of boards of directors, members and managers of LLCs, and those with managerial or ownership interests in other forms of entities. He may be reached at [email protected].

Three recent decisions from the Delaware Court of Chancery provide useful legal insights for corporate executives and those who counsel them. The first case deals with the requirements that must be satisfied before a stockholder or part owner of a company is able to sue based on a claim of excessive compensation. The second case describes the requirements that need to be satisfied if a stockholder seeks records of the company. The last case addresses the attempt of a creditor to pursue a claim for breach of fiduciary duty.

Chancery Rejects Derivative Claim Against LLC

A recent Court of Chancery opinion is notable as a reminder that the same requirement of pre-suit demand futility in the corporate context is also required to be satisfied as a prerequisite to asserting a derivative claim in the LLC context. Dietrichson v. Knott, C.A. No. 11965-VCMR (Del. Ch. April 19, 2017).

Background

This matter involved two 50/50 members of an LLC. One of those members filed claims alleging that an unauthorized salary was taken by the other member, and that the other member misappropriated the proceeds of an asset sale.

Key Takeaways

The court explained that the claims regarding improper compensation and misappropriation of company assets were derivative in nature based on the criteria described in the Delaware Supreme Court's Tooley decision, and that because pre-suit demand futility was not established, the claims were dismissed. The court also referred to Section 18-1001 of the Delaware LLC Act and Chancery Rule 23.1 for the requirements of pre-suit demand applicable in the LLC context.

The court reasoned that the claims of excessive compensation and dissipation of company assets are inherently derivative, and the facts of this case did not allow them to qualify as “dual-natured.” Only in exceptional circumstances can a claim be both direct and derivative.

In addition to dismissing the claims for failure to satisfy the prerequisites of derivative claims, the court dismissed an unjust enrichment claim based on the well-known principle that when a complaint alleges an express, enforceable contract that controls the parties' relationship, a claim for unjust enrichment will be dismissed.

Chancery Grants Section 220 Demand

The Court of Chancery issued an important decision for those who need to understand the latest nuances of Delaware law involving DGCL Section 220, which allows a stockholder to demand corporate records. Over the last 12 years, there have been a plethora of rulings supporting the view that demands pursuant to Section 220 are not for the faint of heart. Rumors of the death of Section 220, however, have been greatly exaggerated, in light of the ruling in Rodgers v. Cypress Semiconductor Corporation, C.A. No. 2017-0070-AGB (Del. Ch. April 17, 2017).

Background

A former CEO of the company involved in this case sought books and records to investigate allegedly excessive compensation paid to the executive chairman of the board, and also alleged that the chairman violated the Code of Business Conduct and Ethics of the company. The company defended the claim based on the argument that the former CEO's stated purpose was not the true purpose, and that the true purpose for the request was not proper. The company also denied the Section 220 demand based on the argument that there were no claims for non-exculpated allegations.

Key Takeaways

The most noteworthy aspects of this opinion are the following:

• The court explained that there remains a very high threshold to establish that the “true improper main purpose” of a demand is something other than the stated primary purpose.
• The court recited the prerequisites for a demand under Section 220, such as having a proper purpose and having a credible basis for claims to support the purpose to investigate wrongdoing. In this post-trial opinion, the court found the testimony of the claimant credible that his primary purpose was proper. Those primary purposes included investigation of wrongdoing such as a conflict of interest in violation of the company's Code of Business Conduct and Ethics, as well as a desire to communicate with other stockholders and attempt to persuade the board to make changes.
• The court distinguished the decision of the Delaware Supreme Court in Southeastern Pennsylvania Transportation Authority v. AbbVie. Specifically, AbbVie stands for the position that when the sole purpose for a Section 220 demand is to investigate wrongdoing of an exculpated claim, a Section 220 demand will be denied. By contrast, in this matter, derivative litigation to pursue claims of an exculpated nature were not the sole motivation to investigate wrongdoing. The other proper purposes included communication with stockholders and evaluation of suitability of members of the board to continue to serve.
• The court rejected the argument that the true purpose of the Section 220 demand in this matter was to pursue a personal vendetta and to assist in an ongoing proxy battle by the claimant. The court cited to cases finding that it is a high hurdle to prevail on an argument that the primary purpose, contrary to the stated purpose of a claimant, is personal animosity or other improper motives.
• The court described the importance of a confidentiality agreement to limit the use of the documents obtained, to minimize the risk that the data would be used for purposes of a proxy contest, although application to the court could be made for seeking approval to use the information for other purposes in the future.

Chancery: Creditor Has No Standing to Sue LLC Derivatively

The Delaware Court of Chancery recently addressed the attempts of a creditor to sue the controlling members of an LLC for breach of fiduciary duty and related claims in connection with allegations that those members deceived the creditor into lending money on false pretenses. In Trusa v. Nepo, C.A. No. 12071-VCMR (Del. Ch. April 13, 2017), the court determined that the creditor had no standing for such claims — nor did a power of attorney provide a basis for standing.

Background

The creditor involved in this matter was verbally seduced into making an investment in the LLC, and was led to believe that his investments would be secured. One of the provisions in the loan documents was a power of attorney that allowed for certain default remedies. After the LLC defaulted on the loans, the creditor learned of various dishonest dealings and misrepresentations regarding the status of the company and what the funds were used for.

Before the Chancery suit was filed, a complaint was filed in the Delaware Superior Court and a default judgment was entered. This Chancery suit was brought claiming that the managing members breached their fiduciary duties. The creditor also sought a dissolution of the LLC in addition to asserting fraud and related claims.

Key Legal Principles

The most noteworthy aspect of this decision is the court's holding that a creditor has no standing to bring derivative claims on behalf of an LLC for breach of fiduciary duty, based primarily on Section 18-1002 of the Delaware LLC Act. Together with Section 18-1001 of the Act, it remains unambiguous that only members and assignees can assert derivative claims on behalf of an LLC. Prior opinions by Chancery and the Delaware Supreme Court endorsed the foregoing interpretation of the Act. See CML V, LLC v. Bax (Bax I) 6 A.3d 238 Del. Ch. 2010) aff'd CML V, LLC v. Bax (Bax II) , 28 A.3d 1037, 1043 (Del. 2011). See also In Re Carlisle Etcetera LLC, 114 A. 3d 592, 604 (Del. Ch. 2015) (explaining that although they are barred from derivative actions, creditors have adequate remedies at law to protect their interests such as liens on assets. This case also addresses equitable dissolution.)

The court also explained that the creditor's power of attorney does not and cannot provide standing that is otherwise denied for the derivative claims attempted by him. The court observed that such a contrary argument ignores the fact that the power of attorney is expressly limited to pursuing remedies provided in the loan agreement.

No Standing for Dissolution Either

Regarding the dissolution claims, Section 18-802 of the Act limits a request for dissolution of an LLC to either a member or a manager. The creditor in this case likewise failed to establish standing for his request for dissolution. Section 18-203(a) of the Act provides seven ways that a certificate of cancellation of an LLC may be filed. The ability to file such a certificate did not help this creditor because only after dissolution and winding up of an LLC may a creditor seek appointment of a trustee or a receiver in connection with a prior dissolution.

Regarding the extreme remedy of “equitable dissolution,” the court found insufficient facts in the record to justify such an exercise of the court's authority.

Fraud Claim Fails

The court emphasized the truism that a simple breach of contract cannot be bootstrapped into a fraud claim. For example, the court quoted from prior case law holding that: “a party's failure to keep a promise does not prove the promise was false when made, and that the plaintiff did not adduce evidence showing that the defendant intended to renege as of the time it made the promise.”

Material Omission

The court found that the claim that a material omission amounted to fraud was not adequately alleged for several reasons. The court explained that in an arm's-length negotiation: “where no special relationship between the parties exists, a party has no affirmative duty to speak and is under no duty to disclose facts of which he knows the other is ignorant even if he further knows the other, if he knew of them, would regard them as material in determining his course of action in the transaction in question.”

The court further reasoned that a fraud claim cannot start from an omission in an arm's-length setting. Rather, if a party chooses to speak, then he cannot lie, and “once the party speaks, it also cannot do so partially or obliquely such that what the party conveys becomes misleading.”

*****
Francis G.X. Pileggi is a Member-in-Charge of the Wilmington office of Eckert Seamans Cherin & Mellott. His litigation practice emphasizes representation in high-stakes disputes of corporations, stockholders, members of boards of directors, members and managers of LLCs, and those with managerial or ownership interests in other forms of entities. He may be reached at [email protected].