Examining the Interplay Between Exculpation Clause and Fiduciary Duty

Prior to consummating the X7 acquisition, SDI and, in particular, its managers — David Stienes, Michael Levenberg and Douglas Baker — hired Grant Thornton "to investigate X7, to review X7's financial records and internal controls and to advise [the SDI managers] on the proposed X7 acquisition." Following its retention, Grant Thornton provided the SDI managers with a "financial and tax due diligence" report. As part of its report, Thornton emphasized that there were several "key issues" for the SDI managers to consider. In particular, Grant Thornton had concerns with X7's interim financial statements and felt that they did not accurately report the monthly financial results of X7 and that this would lead to "significant volatility in [X7's] operating results and cash flows."

In its report, Grant Thornton also noted that X7 did not regularly update its budgeted revenue and costs for change orders and, as such, it could not "readily convert interim historical financial information to a basis consistent with the year end." Grant Thornton also identified additional concerns with X7's lack of recorded inventory, its cash activity analysis and that X7 had significant age receivables of more than 90 days.

Notwithstanding these concerns, the SDI managers closed on the X7 acquisition and acquired X7. Following the closing, two of X7's former owners, David Taylor and Paul G. Garver (who, along with the SDI managers, were sued by the liquidating trustee) were retained as X7's CEO and president, respectively.

Not surprisingly, the X7 acquisition did not meet the parties' expectations. Specifically, X7 was losing money on its existing contracts and, at the end of the day, instead of generating revenue for SDI, the "X7 acquisition generated losses, resulted in SDI's reduced credit availability from its lender and pushed SDI into debt covenant violations for which SDI had to seek waivers and make capital infusions." Eventually, SDI's deteriorating financial condition led to both SDI and Opco filing for bankruptcy.

As part of its two count amended complaint, the liquidation trustee sued the defendants for their decision to go forward with the X7 acquisition and for their failure to establish proper policies and controls to address the problems at X7 following the acquisition. Specifically, the liquidation trustee alleged that "even after defendants learned that over $1 million of X7's contracts were underestimated, they still failed to inform themselves fully of the extent of the underestimated contracts, which caused X7 to continue to enter into such underestimated contracts after the X7 acquisition," and that their failure to inform themselves led to additional losses incurred in the ongoing operation of X7.

Not surprisingly, the defendants filed motions to dismiss each count, alleging that the complaint failed to allege that the defendants' actions regarding the acquisition or management of X7 post-acquisition reached the standard of gross negligence under Delaware law, and that their actions were justified by the defendants' reasonable business judgment. The defendants also contended that the exculpation clause contained in the SDI LLC agreement barred the liquidating trustee's claims because the complaint failed to allege facts that would demonstrate that the defendants were grossly negligent.

Standard of Care

In adjudicating the motion to dismiss (and, in particular, Count I of the amended complaint, which dealt with the pre-acquisition claims and whether the actions of the SDI managers in proceeding with the X7 acquisition constituted "gross negligence" and "bad faith" in violation of their fiduciary duties), the court first examined the LLC operating agreement to determine the appropriate standard of care. Pursuant to the SDI operating agreement, a manager of the company was supposed to act with "that degree of care that an ordinarily prudent person in a like position would use under similar circumstances." Furthermore, the operating agreement limited the SDI manager's liability for breach of any duty of care "except in the case of bad faith, fraud, gross negligence or willful misconduct." As a consequence, the court noted that the SDI managers could only be held liable for a breach of the duty of care "if they acted in bad faith, committed fraud, were grossly negligent, or acted with willful misconduct." Since there were no allegations of fraud, willful misconduct or bad faith in the amended complaint, the court was left to determine whether the actions complained of in the complaint constituted gross negligence.

According to the court, gross negligence in Delaware has been defined as a "higher level of negligence representing an extreme departure from the ordinary standard of care," citing A & J Capital v. Law Office of Krug, C.A. No. 2018-0240-JRS (Del. Ch. Jan. 29, 2019), judgment entered sub nom., Capital v. Law Office of Krug, No. 2018-0240-JRS (Del. Ch. Feb. 8, 2019). Furthermore, in order to establish gross negligence, the court noted that a plaintiff must assert that the defendant was recklessly uninformed or "acted 'outside the bounds of reason.'" In addition, the court also noted that Delaware bankruptcy courts have also found that gross negligence "generally requires directors and officers to fail to inform themselves fully and in a deliberate manner."

Turning to the facts alleged in the amended complaint, the court found that in this case, the SDI managers performed appropriate due diligence by retaining Grant Thornton to investigate and advise them about the X7 acquisition. The court also rejected the liquidating trustee's argument that, although the SDI managers retained Grant Thornton, these defendants were still negligent because the Grant Thornton report "informed them that the financial and other information they were relying on to acquire X7 was unreliable, and therefore, they were entirely uninformed as to what they were acquiring." In rejecting this assertion, the court found that there were "no facts plead to support this allegation." As observed by the court, the SDI managers retained Grant Thornton to issue the report "in order to be adequately informed of X7's condition — good or otherwise. Certainly, conducting the appropriate due diligence prior to closing on an acquisition cannot amount to gross negligence." While the court recognized that the acquisition ended "badly," the court also noted that such actions do not "amount to gross negligence." Finally, the court noted that while Grant Thornton found several issues with X7's financial reporting, the recommendations that Grant Thornton made were all post-acquisition recommendations. As the claims of the Liquidating Trustee were focused as to what the SDI managers did prior to the X7 acquisition, the court concluded that the complaint lacked any "factual support" for any allegation of gross negligence and, as such, dismissed that claim. The court also noted that the decision of the SDI Managers to acquire X7 was also protected by the business judgment standard under Delaware law. As noted by the court, in order for a plaintiff to overcome the business judgment rule, a "plaintiff must allege facts that raise a reasonable inference that the board of directors either breached its duty of loyalty or duty of care with regard to the transaction at issue." Solutions Liquidation. In the event that a plaintiff fails to satisfy this burden, "a court should decline to substitute its judgment for the decision of the board, provided the board's decision can be attributed to a rational business purpose," citing Xtreme Power Plant Trust v. Schindler (In re Xtreme Power), 563 B.R. 614, 642 (Bankr. W.D. Texas 2016). In this case, the court found that the SDI managers, in going forward with the X7 acquisition, were looking to grow SDI's revenue and, as such, their "decision to acquire X7 is thus consistent and related to the rational business purpose." Consequently, the court found that the SDI managers' decisions were entitled to the business judgment standard of review.

Breach of Fiduciary Duty

The court then turned its attention to Count II of the amended complaint, which asserted a breach of fiduciary duty claim against all of the defendants "regarding their alleged failure to take adequate steps to address known problems at X7 post-acquisition." In particular, the Liquidation Trustee alleged that the defendants "failed to inform themselves fully of the extent of X7's underestimated customer contracts, which were its primary source of revenue" and, as a result, "lead to X7 continuing to enter into such underestimated contracts, causing them to lose money by fulfilling the contracts."

In addressing this issue, the court noted that the liquidating trustee, in the amended complaint, alleged that the defendants did, in fact, learn that X7 was losing money by underestimating these contracts and, as such, these facts gave "rise to a reasonable inference that the defendants failed to fully inform themselves as to the extent of the underestimated contracts." The court found that this was sufficient to establish a claim of gross negligence. Because it found that Count II of the amended complaint adequately set forth a gross negligence claim against the defendants, the court was able to dispose of the defendants' remaining argument that this claim was barred by the exculpatory clause contained in the LLC agreement. In rejecting this argument, the court noted that "the plain language of the SDI LLC agreement establishes that the grant of exculpation will not extend to instances in which the act or omission of a manager is attributed to bad faith, fraud, gross negligence, or willful misconduct." As the court had already found that the liquidating trustee pleaded that all of the defendants were grossly negligent "by way of failing to inform themselves fully as to the extent of X7's underestimated customer contracts, causing the company to continue to enter into such underestimated contracts," the court concluded that that the exculpation clause did not bar the trustee's breach of fiduciary duty claim against the defendants and, therefore, did not dismiss this count.

Conclusion

This case represents a comprehensive analysis of Delaware law regarding breach of fiduciary duty claims and highlights the tension/interplay between the law and a party's attempt to contract around such duties through the use of expansive exculpatory clauses contained in a company's operating agreement/corporate charter.

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Lawrence J. Kotler is co-chair of the bankruptcy and fiduciary representations division of Duane Morris' business reorganization and financial restructuring practice group. He represents Chapter 11 debtors-in-possession, Chapter 11 trustees, Chapter 7 trustees, liquidating trustees, creditors' committees, secured creditors and large institutional unsecured creditors in all facets of bankruptcy. This article also appeared in Delaware Business Court Insider, an ALM sibling of The Bankruptcy Strategist.