Delaware Corporate Law Update

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

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.

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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

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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.