Delaware Corporate Law Update

Updates on Delaware Corporate Law by Evan O. Williford, Esq., Delaware Corporate Litigation Attorney.

Delaware Courts: New Five P.M. Deadline

The Delaware Supreme Court recently ordered a new 5:00 p.m. deadline for most Delaware state court filings to be considered timely filed that day.  The action follows on the heels of the District Court’s 6:00 p.m. filing deadline, adopted in 2014.  Wise Delaware and out-of-state counsel will carefully consider any necessary measures (such as moving work to the day before) this new deadline will require.

The order comes into effect September 14.  All filings in non-expedited cases before Delaware state courts – except initial pleadings and notices of appeal – must be made before 5:00 p.m. Eastern Time to be considered timely filed that day.

This change comes based on a report recommending this and several other changes to improve work/life balance for lawyers and their staff.  The report noted that this in particular was a “contested” change.  The report recognizes a criticism that the earlier deadline will simply result in more work on the previous day (or night).  However, the report argues that when late filings are “the result of the human tendency to delay until any deadline, especially on the part of those who do not bear the worst consequences of delay, what can result is a dispiriting and unnecessary requirement for litigators and support staff to routinely be in the office late at night to file papers that could have been filed during the business day.”  And in the case of expedited filings, where procrastination may be less of a factor, the deadline remains midnight.

The Supreme Court also ordered Delaware courts to consider other work/life balance policies discouraging (1) deadlines on Mondays or the day after a holiday, (2) court opinions deciding dispositive motions or post-trial relief after noon on Fridays or 4:00 p.m. any other day, and (3) scheduling oral arguments or trials in August.

Delaware and out-of-state counsel would do well to reflect on the changes in workflow that will be necessary to submit the same high-quality, often labor-intensive work product.  As Francis Pileggi notes in his blog, California counsel will need to complete any work on filings several hours before typical close of business there.  And if there is extra work the day before that is not certain to be completed the next day (whether that be from procrastination, miscommunication, or simply the human condition), any overtime/nighttime work will have to be done the night before.

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Filed under: Court of Chancery, Delaware Supreme Court, Expedited

Enforcing The Court of Chancery – Bench Warrants

“Court of Chancery” and “bench warrants” are two phrases you don’t often see together.  Perhaps that is a testament to how often they are usually obeyed.  But as a recent case, Deutsch v ZST Digital Networks, Inc., demonstrates, the Court does have the power to issue them in appropriate cases.

Plaintiff brought a books and records case against a Delaware corporation that, through holding companies, did business in China.  The company defaulted, and the Court entered judgment against it.

Directors and senior officers of the corporation, Chinese nationals Bo Zhong and his son Lin Zhong, had a long history of defying and frustrating the Court’s orders.  Plaintiff sought to enforce the default judgment, and the company did not comply.  The Court appointed a receiver who spent years and significant resources attempting to cause the company to comply but was continually frustrated.

Finally, the receiver moved to issue bench warrants to arrest the Zhongs.  They appeared before the Court and raised objections, resulting in this opinion.

The Court first rejected the argument that the Zhongs as non-parties could not be held in contempt.  It noted that an order binds not only the named parties but also those “identified with them in interest, in ‘privity’ with them, represented by them or subject to their control.”  Thus, the order extended to “directors, officers, and employees” of the company, such as the Zhongs.

The Court noted that personal jurisdiction was satisfied under 10 Del. C. § 3114, providing personal jurisdiction over directors of a Delaware corporation.

The Zhongs then made due process arguments against the bench warrants.  The Court ruled that the contempt ruling sought would be civil and not criminal, since the requested arrest would only last until the contemptuous conduct ceased, which meant less process was due.  Even with the lesser requirements for civil contempt, the Court did in part accept the Zhongs’ due process arguments, noting that the receiver sought to hold the Zhongs in contempt of orders which did not identify the Zhongs by name and imposed broad mandates (such as giving the receiver authority over books and records and requiring cooperation) rather than specific demands.

Thus, the Court decided to enter a more specific order directing the Zhongs to take actions that the receiver had identified as being necessary to comply with the Court’s orders.  This would give the Zhongs a final opportunity to comply with the Court’s order and another hearing should noncompliance cause the receiver to move again for the issuance of a bench warrant.

Key Takeaways:

  • The Court of Chancery does have the power to enforce its rulings through bench warrants;
  • The Court can issue warrants as to persons not a party to the lawsuit, even persons not named specifically in the Court order allegedly disobeyed; but
  • Such circumstances may provide fertile grounds for arguments from arrestees including personal jurisdiction and due process.

Filed under: Uncategorized

2018 DGCL Amendments

Every year changes are typically made to the Delaware General Corporation law (the “DGCL”), and this year is no different.  This post will focus on several that seem particularly noteworthy.  The legislature has passed those changes, and they are currently pending approval by the governor.

Market-Out Exception For Intermediate-Form Mergers – Delaware law has long made available an “appraisal” cause of action for certain shareholders to require the Court of Chancery to value their shares under certain circumstances.  Delaware had previously amended that right in “long-form” mergers under 8 Del. C. § 262 by including a “market out” exception.  Under this exception, appraisal rights may not be available for shares that are listed on a national securities exchange or held of record by more than 2,000 holders (which shares the market already arguably values).

This amendment would extend the market-out exception to so-called “intermediate-form” mergers under 8 Del. C. § 251(h).  (In an intermediate-form merger, two companies’ boards approve a merger agreement under which one company offers to buy all of the other company’s voting stock; and enough shares are tendered to the first company that it owns more of the other company’s shares than would be needed to approve the merger, thus making a stockholder vote unnecessary.)

Amendments to Section 204 Governing Ratification – In 2013, the DGCL was amended to add a new provision, 8 Del. C. § 204, which formally allows corporations to ratify certain defective corporate acts and stock.  This most recent amendment would make certain changes to that statute.

First, corporations would be able to use Section 204 even in circumstances in which there is no valid stock outstanding.  (Section 204 generally requires approval by both the board and the stockholders, but in this circumstance only board approval would be required).

Second, Section 204 clarifies that any act or transaction within a corporation’s power under the DGCL would be subject to ratification.  In Nguyen v. View, Inc., the Delaware Court of Chancery had arguably adopted a narrower view, that an act was not within corporate power and therefore could not be ratified if not approved according to the corporation’s organizational documents and the DGCL.  This amendment therefore would clarify that Section 204 has a broader application.

Filed under: Appraisal, Ratification

Goggin: LLC Fudges Fiduciary Duties

In MHS Capital LLC v. Goggin, the Court of Chancery had to interpret an oddly-drafted LLC agreement provision regarding fiduciary duties.  Goggin shows why it is in the interests of both LLC management and investors to have knowledgeable lawyers carefully review such documents.  It also shows a Delaware court dealing with the difficult task of interpreting such a provision and coming to a result that is equitable but also consistent with its plain language.

The lawsuit arose from a transaction in which the LLC’s manager allegedly diverted assets in a bankruptcy proceeding from the LLC to a group of entities of which the LLC was only one.  Plaintiff filed suit; the individual defendants moved to dismiss the complaint.

The LLC’s operating agreement contained two interesting provisions relating to fiduciary duties.  First, the agreement required the manager to act “with the care an ordinarily prudent person in a like position would exercise under similar circumstances” (as well as “in good faith” and “in a manner [he] reasonably believes to be in the best interests of the Company”).  As Delaware corporate litigation practitioners know, the default Delaware entity duty of care typically only requires behavior that is not grossly negligent, it does not impose the much higher standard of ordinary care.

Second, the agreement provided that the manager was not “liable . . . for monetary damages” for breach of his or her “duty as a Manager, except as otherwise required under the [Delaware LLC] Act.”  It is not uncommon to see waivers of damages for violating the duty of care (“Section 102(b)(7) provisions”), but those typically exclude other duties (such as good faith).

Defendants did not argue that the alleged conduct was not a breach of the fiduciary duties set forth in the agreement.  Rather, defendants argued that plaintiff’s case should be dismissed because the waiver of damages precluded a remedy.  The Court, however, emphasized that plaintiff was seeking to “disgorge the monetary proceeds received” from the alleged misconduct and “impose a constructive trust”.  The Court ruled that if a claim is stated, “the nature of [] relief [for that claim] is not relevant and need not be addressed.”  As such, the Court “need not decide whether [plaintiff’s] request for some forms of equitable relief is so close to a request for monetary damages that it runs afoul of the exculpatory provision.”  In so ruling, the Court stated that “the way the operating agreement’s ‘Manager’ standard of care—good faith and ordinary care—is meant to work with the exculpatory clause, which purports to eliminate all damages, is unclear to me.”

Faced with a non-standard fiduciary duty provision, the Court ruled that – in this case and at this stage of the litigation – the provision did not preclude plaintiff’s claims.  Thus, in a way the provision ended up costing both sides: defendants by not eliminating costly discovery and further proceedings on plaintiff’s claims; plaintiffs by preserving a chance that after such costly further proceedings the Court might hold that the appropriate remedy is unavailable after all.

The Goggin case shows the importance of having knowledgeable lawyers draft or review fiduciary duty provisions in LLC agreements before they are finalized.  Delaware fiduciary duties have many wrinkles that even an intelligent layperson, or a lawyer not familiar with the subject matter, might miss.  Costly litigation or uncertainty may be the price for not reviewing such provisions carefully.

Filed under: Court of Chancery, Fiduciary Duties

What’s the Big Deal with Blockchain?

Over the past year or so there has been a good deal of discussion about using “blockchain” technology as a method to store corporate records, particularly about stockholders.  But what exactly is blockchain anyway, and is it coming soon to a Delaware corporation near you?

What is “blockchain”?  Blockchain technology was invented by the unidentified founder (alias “Satoshi Nakamoto”) of, and used in the establishment of, the currency “bitcoin”.  For those who have been living under a rock for the past ten years, bitcoin is a type of money that operates without a central authority and, as of January 11, 2018, had a market capitalization of approximately $240 billion.

Blockchain technology operates by replacing a single record-book with multiple identical record-books maintained by a network of participants.  For instance, with respect to bitcoin, it has enabled the creation of an entirely electronic currency (no actual coins or counterfeit-proof paper bills needed) without the necessity for a central authority to keep records of it (which central authority would need to be trusted and possibly paid by transaction fees).

There are several ways that technology has, both generally and with respect to bitcoin, to reduce the possibility of fraud.  For instance, it can apply decision rules to resolve disputes, such as when copies of the record-book disagree with others as to a transaction.

So what is the connection to Delaware corporate law?  One way in which blockchain technology shows promise is as a replacement for record-books of corporate stockholders.  As corporate lawyers know, but John Q. Stockholder might be surprised to learn, “stockholders” of large publicly held Delaware corporations frequently don’t hold their own shares.

Rather, they are what the law calls “beneficial owners”.  For historical reasons, the system that has evolved in the Unites States is that most such shares of stock are held by an organization called Depository Trust Company (“DTC”) and issued in the name of its nominee, Cede & Company (“Cede”).

So, if a “beneficial owner” wishes to vote their shares, they frequently must tell their broker to tell Cede to vote the way they want or use some other equivalent process.  This can give rise to costly unfair results.  For instance, in one phase of the Dell appraisal litigation, because the name of the stockholder of record changed, Delaware law requiring continuous ownership of shares was violated, resulting in a lost potential damages award.  In another, a mistaken instruction cost a stockholder a potential $200 million award.

One of the long-term promises of blockchain technology is to replace DTC, thereby reunifying beneficial and record ownership and hopefully eliminating some potentially unfair results under Delaware law.  A recently published article by Vice Chancellor J. Travis Laster and Skadden Arps lawyer Marcel Rosner, Distributed Stock Ledgers and Delaware Law, 73 Bus. Law. 319 (Spring 2018), goes into detail regarding blockchain technology and the promise it holds for various facets of Delaware law, and is recommended reading for those looking for a deeper understanding.

Is blockchain technology coming to a Delaware corporation near me?  The answer is maybe, but slowly.  The Delaware General Corporation Law was amended in 2017 to permit, theoretically and under certain conditions, keeping corporate records like stock ownership in blockchain format.  That being said, law and corporate America can be conservative.  The path is open for enterprising Delaware corporations to use and show the success of blockchain recordkeeping, and perhaps others will follow.

In the meantime, as Vice Chancellor Laster recommended in the first Dell decision discussed above, Delaware courts (or the Delaware legislature, for that matter), could consider changing Delaware law to ameliorate these argued unfair results.

Filed under: Appraisal, Court of Chancery

Back from the Dead: Inadequate Reserve Revives LLC

In a recent decision, Capone v. LDH Management Holdings LLC, the Delaware Court of Chancery nullified the certificate of cancellation of a Delaware LLC.  The Court did so because the LLC had established no reserve for legal claims previously known to it.  The decision highlights the requirement under Delaware law that, before an LLC is cancelled, it must make reasonable provision for known nonfrivolous claims:  zero is not enough.  If a reasonable reserve is not made, the entity may (as happened here) later be revived.

Plaintiffs were holders of units in a Delaware LLC (“Management Holdings”), which in turn was valued based on its holdings of units in another LLC (“LDH”).  Under the former LLC’s agreement, Management Holdings had the right to (and did) redeem plaintiffs’ units at a price set by a specified process.  Plaintiffs claimed that the valuation of LDH by which their units were valued was too low by some half a billion dollars, and they voiced those claims (vociferously in some cases) to management.

Nevertheless, Management Holdings’ certificate of formation was cancelled, with no reserve having been established for such claims.  Plaintiffs sued in New York on their claim that the valuation had been improper and thus a breach of contract.  When they discovered that Management Holdings had been cancelled, they filed a lawsuit in Delaware to nullify the certificate of cancellation.

On cross-motions for summary judgment, the Court granted judgment for plaintiffs.  After reviewing the applicable sections of the Delaware LLC Act and the nature of plaintiffs’ claims, the Court ruled that defendants were in fact aware of the claims due to plaintiffs’ complaints.

Next the Court discussed the establishment of a reasonable reserve under 6 Del. C. § 18-804.  In the Court’s view, that would involve factors including the potential amount of the claim as well as the likelihood of it becoming a liability.  The Court noted that a claim could in fact be “so obviously frivolous that a reserve of zero dollars would likely be sufficient”.  That being said, it concluded that plaintiffs’ reading of the LLC agreement was a “reasonable construction” and not “indisputably wrong,” and therefore a reserve of $0 was a violation of the Delaware LLC Act.  Accordingly, the Court nullified the LLC’s certificate of cancellation, thereby reviving the entity.

Key takeaways from the Court’s decision:

  • Establishing a $0 reserve for a nonfrivolous claim for a substantial amount of money may well result in an LLC’s certificate of cancellation being nullified.
  • Managers of an LLC must make reasonable provision for any known potential claims before filing a certificate of cancellation. In doing so, they may consider the likelihood that the claim will be successful, along with the potential liability if successful.
  • “[E]ven a relatively weak claim may justify a reserve,” particularly when the potential damages are large.

Filed under: Court of Chancery, LLC

Delaware Chancery Orders Defendant Directors Deposed on SLC’s Motion to Terminate Claims

Courts are restrictive in granting a plaintiff discovery in connection with the motion of a special litigation committee (an “SLC”) to terminate claims.  That is particularly true with regard to discovery directed toward defendant directors.  In a recent transcript decision, Judy v. Agar, the Court of Chancery denied motions of two defendant directors for protective orders against their depositions and certain document discovery.  The Court cited the lengthy past litigation history of the company (characterizing it as having a “black halo”), but also discussed the kinds of allegations that in its view justified such depositions.  This decision is useful because there is little caselaw discussing the scope of discovery in this context other than from an SLC.

In this case, plaintiffs sought and received discovery from the SLC.  The key question on defendants’ motions was what discovery plaintiffs would be permitted from certain defendant directors who benefited from the SLC’s motion to dismiss certain claims.

The Court denied the motions and began with the observation that this was not “a typical case”.  Rather, it continued, the case was one “that I’ve had for however many years now where people hide things, they lie, they engage in fraud.”  “No phase of this company’s multi-phase history has ever involved actions that are inspiring of confidence,” said the Court.  But for that background, the Court said it would have been “highly likely” to “limit the scope” of discovery.

The Court also observed that other circumstances “were probably sufficient to warrant a deposition regardless”.  One director had engaged in communications with the (single-member) SLC concerning its functioning such as whether an in-person meeting with plaintiffs’ counsel was appropriate, fees the SLC should pay, and changes in SLC composition upon the election of new directors.  The Court held that those communications “are probably sufficient to warrant a deposition regardless.”  Similarly, it held that another director’s relationships with certain parties, particularly the SLC, were sufficient to warrant his deposition.

Separately, the Court noted that no live testimony would be permitted in the hearing on the SLC’s motion to terminate certain claims (a “Zapata” hearing), reasoning that the applicable standard was akin to a summary judgment motion.

The Court did not lay down a new rule or standard for discovery from defendant directors as to an SLC’s motion to terminate litigation.  It is a given that such discovery may be difficult to obtain and may require a particularized showing from plaintiff.  The Court, however, may be influenced by extensive past bad conduct on the part of the company or those associated with it.   It may also grant discovery into (1) communications between the SLC and the defendant director about the functioning of the SLC; and (2) specific relationships between the defendant director and others, particularly the SLC, that could have a bearing on the SLC’s motion.

The Williford Firm LLC serves as counsel for plaintiffs in this action.

Filed under: Court of Chancery, Derivative Actions, Zapata

Owners of a Delaware Business Entity

In talking about how a Delaware business entity functions, it is important to keep in mind three groups of people: (1) the managers; (2) the directors; and (3) the owners.  Not all business entities will have all three, and in some (particularly small) entities they might be the same people.

But each of these groups have different jobs.  The managers (or officers) run the entity on a day-to-day basis.  The directors hire and fire the managers and oversee their performance and the entity’s business.

And then there are the owners.  The owners of a Delaware corporation are its “stockholders;” and the owners of a Delaware LLC are its “members”.  As important as the managers are, as powerful as the directors can be, none of them own the entity – the stockholders or members do.

So what rights do the owners have?  We can think about their rights as generally dividing into three categories – transfer rights, other financial rights, and voting rights.

The first category of rights the owner has stems from the fact that they have a percentage ownership in the entity itself.  For example, stock in a well-known and publicly traded Delaware corporation like The Walt Disney Company will have a recognized price; the stockholder can sell their stock for that price.  To many stockholders that may be only right they care about.  An entity’s organizational documents could limit those rights.

Owners can have other financial rights.  An entity may choose to return a share of its profits to stockholders through “dividends”.  When a corporation is liquidated, the money left after it has paid its debts and sold its assets (if any) is divided among the stockholders.  And if a corporation is acquired through a merger, its stockholders could receive an amount equal to their interest in its fair value.

All of these rights would be worthless if not for the right to vote.  Owners have the right to vote on certain important matters, such as who will manage and run the entity.  For instance, a stockholder in a corporation may have the right to elect directors.  Stockholders may also vote on certain fundamental corporate changes such as mergers, dissolutions, and amendments to the articles of incorporation.

Filed under: Basic Law of Corporations

Registered Agents

Every business entity formed in Delaware – whether a corporation, LLC, or some other form – is required to have a “registered agent”.  A registered agent is a person or business physically located in Delaware that can receive documents and forward them on as necessary.

Why have a registered agent when someone can just send mail to business headquarters?  Because Delaware business entities and their managers can be sued in Delaware courts, someone must be present in Delaware to receive “service of process” (that is, typically the complaint along with a summons ordering the defendant to respond).  This reduces the risk that a business will intentionally avoid being served and thus having to defend itself in court.

There are many registered agents to choose from; they can be found quickly online and are often very inexpensive.  Some registered agents serve hundreds or thousands of businesses.

Once a registered agent has been hired, the business must designate that registered agent on a filing with the Delaware Division of Corporations.  A business can change its registered agent anytime by making a filing with the Delaware Division of Corporations noting the change.  You can find any Delaware business entity’s registered agent on the Delaware Division of Corporations’ website.

If a business entity fails to maintain a registered agent, then the Delaware Division of Corporations will serve as a fallback registered agent.  Eventually the entity’s certificate of incorporation or formation may be canceled, however, making it difficult or impossible for the entity to function legally.

Filed under: Basic Law of Corporations

Forming a Delaware Entity

So how does someone actually form a Delaware entity?  As it turns out, the actual tasks required to form one are not that expensive, nor do they take a lot of time.   But it is important to understand in advance why you want to form such an entity, as that will affect various choices you make along the way.  And, of course, it is always a good idea to get the advice of a qualified lawyer.

First, you must decide what kind of entity you want.  For example, do you want to form a corporation or a limited liability corporation (“LLC”)?  There are a number of other forms, though the ones specifically mentioned are among the most common.  We have discussed these common entity forms and their characteristics in a previous post – keep those in mind when selecting an entity form, do your own research and thinking, and seek qualified legal advice.

You will also need to choose a name for the entity.  That name will have to follow certain rules that you can find out from the Delaware Division of Corporations.  For example, obviously, it cannot be the same as an existing business.  There are other rules, such as that a corporation must including a word like “incorporated” or “corporation” (or an abbreviation like “inc.” or “corp.”).

If the entity will not have an office in Delaware, you will need to hire a “registered agent” and put their contact information on the forms you file with the Division of Corporations.  A registered agent is a person or company whose job it is to accept service of process if your entity is sued in a lawsuit in Delaware.  Hopefully that will never happen!  But the good news is that registered agents are relatively cheap.  A number of companies provide that service for a relatively low yearly price; information regarding them is available online.

It is a very good idea – and sometimes necessary – to put together certain organizational documents.  We have briefly discussed in a previous post what organizational documents are and how they create rules for that entity.  An attorney can help you do that, or you can look online for various resources, such as sample documents, to help you do that yourself.  If you are doing that yourself, be very careful to make sure that all the rules make sense for the entity you are forming.  Many lawsuits are caused or made worse when an entity has rules that apply not because they made sense for that entity, but because someone just adopted them without thinking about it!

Next, go to the Division of Corporations’ website and find out what they need from you to form your entity.  They will charge a filing fee, depending on what type of entity you want to form and whether you are in a hurry.  They will also tell you whether you need to file the entity’s organizational documents, and if so which ones.  When your paperwork is ready, mail or fax it to the Division of Corporations.

Now you have formed your own Delaware entity!  A Delaware entity has certain things it must do every so often in Delaware to maintain its good standing.  For example, corporations must file an annual report and pay a franchise tax; other entities similarly have to pay an annual tax.  Keep in mind there are a number of other things you may want or have to do that are outside the scope of this post, such as (1) getting an “Employer Identification Number” from the U.S. Internal Revenue Service; and (2) registering to do business in the State of Delaware, or another state.

Filed under: Basic Law of Corporations

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Disclaimer

Delaware Corporate Law Update solely reflect the views of Evan Williford of The Williford Firm, LLP. Its purpose is to provide general information concerning Delaware law; no representation is made about the accuracy of any information contained herein, and it may or may not be updated to reflect subsequent relevant events. This website is not intended to provide legal advice. It does not form any attorney-client relationship and it is not a substitute for one.