Chancery Court Finds That Hedge Fund Manager Breached Fiduciary Duties. After a trial in the case Paige Capital Management, LLC v. Lerner Master Fund, LLC (C.A. No. 5502-CS, Del. Ch. Aug. 8, 2011), the Chancery Court found that a hedge fund manager had violated the Partnership Agreement with the fund’s seed investor, and more importantly, her fiduciary duties to the fund and the investor. The dispute arose out of Paige Capital Management's Partnership and Seeder Agreements with Lerner Master Fund, under which Lerner invested $40 million in Paige. Under the agreements, Lerner was generally precluded from withdrawing its capital for the first three years, after which the capital could be withdrawn without penalty. However, the Partnership Agreement also contained a "Gate Provision" that enabled the manager to restrict a withdrawal of capital if it would result in over 20% of the fund's assets being withdrawn in any 6-month period. During the first three years of the fund's existence, the manager deployed very little of the fund's capital and signed up no new investors. Lerner expressed its concerns about Paige's investment strategies and its ability to attract additional capital and ultimately notified Paige of its intention to withdraw at the end of the three-year period. In response, Paige invoked the Gate Provision and filed suit in the Chancery Court seeking a declaratory judgment that the Gate Provision allowed the fund to prevent the withdrawal of all of Lerner's capital. Lerner counterclaimed for breach of contract, breach of fiduciary duties, and dissolution of the fund. Applying New York law to the contract claim, the Court found that the Seeder Agreement and Partnership Agreement, when read together, supplanted the Gates Provisions with the Seeder Agreement’s provisions allowing withdrawal without penalty after the 3-year period expired.

The Court then turned to Lerner's claim that refusing to waive the Gates Provision was a breach of the manager's fiduciary duty to the fund. As a threshold matter, the Board noted that the manager was subject to fiduciary duties in her capacity as managing member of the fund's General Partner, since a director, member or officer of a corporate entity serving as the general partner of a limited partnership who exercises control over the partnership's property owes fiduciary duties directly to the partnership and the limited partners. The Court rejected the manager's "novel" argument that because the manager also owed fiduciary duties to the General Partner, it would be impossible both to waive the Gates Provision and satisfy those duties. Instead of "absolv[ing] a governing fiduciary of responsibility for acting in its own self-interest," the Court explained, the presence of a conflict of interest occasions "more searching judicial review." The Court also rejected the argument that the provision in the Partnership Agreement granting the General Partner "sole discretion" in its decision-making precluded application of fiduciary duties, holding that sole and absolute discretion is circumscribed by the duty of loyalty and exercise of good faith and that any contractual displacement of fiduciary duties of loyalty and care must be made with clarity. Because the decision to use the Gates Provision was made for the purpose of enabling the manager to continue to collect fees rather than to protect the General Partners' 0.01% investment in the fund, the refusal to waive the Gates Provision was self-interested and was therefore a violation of the duty of loyalty. Noting that the manager had consistently represented the Gates Provision as a means of protecting the management fee stream and at trial had been unable to articulate a non-self-interested reason for its use, the Court concluded that the manager's reading of the Partnership Agreement was not in good faith. Refusing to "exculpate fiduciaries for self-serving interpretations of governing instruments" the Court found that the manager could not take refuge in the "good faith" exculpation provisions of 6 Del. Code 17-1101(e), and that the manager and her husband, who served as General Counsel to the fund, were not entitled to indemnification for their legal expenses. The Court also held that the manager was not entitled to indemnification of expenses related to the expanded litigation resulting from Lerner's counterclaims, since the counterclaims were compulsory; in addition, reimbursement of legal expenses related to defamation claims filed against Lerner was not available since these claims were not in connection with the performance of the manager’s duties to the fund.  Link to Chancery Court Opinion: http://courts.delaware.gov/opinions/download.aspx?ID=158540

Delaware Supreme Court Confirms That Creditors of Limited Liability Companies Lack Standing for Derivative Suits; Finds Standing Statute Constitutional. In CML V, LLC v. Bax (No. 735, 2010, Del. Supr. Sept. 2, 2011, corrected Sept. 6, 2011), the Delaware Supreme Court affirmed the Chancery Court’s holding that creditors of an insolvent limited liability company have no standing to sue derivatively on the LLC’s behalf. As discussed in Vol. 10.3 [Link?] the plaintiffs, creditors of JetDirect Aviation Holdings, LLC, had brought suit alleging that the managers breached their duty of care by approving transactions without adequate information, acted in bad faith by failing to implement and monitor an adequate system of internal controls, and violated their duty of loyalty by engaging in self-interested transactions with the company. The Chancery Court dismissed the claims, holding that §18-1002 of the Delaware Limited Liability Company Act requires the derivative plaintiff to be a member or an assignee of the LLC, and that §18-1001 of the not provide for any other classes of derivative plaintiff.

On appeal, the plaintiffs argued that §18-1001 only guarantees derivative standing for members and assignees, but does not limit standing to those two groups, and that read in conjunction with §18-1002, the legislative intent was to mimic the analogous section of the Delaware General Corporation Law, which has been held not to bar derivative standing for creditors. The Supreme Court disagreed. It found the language of §18-1002 to be unambiguous and declined to engage in “any extraneous contemplation of, of intellectually stimulating musings about, the General Assembly’s intent.” It also rejected the argument that a plain reading of §18-1002 yields an absurd result (by creating standing for corporate creditors but not for LLC creditors), pointing out that the General Assembly is free to promote “maximum business entity diversity” by giving investors the option to invest in corporate forms offering different “bundle[s] of rights.

The plaintiffs also contended that by limiting derivative standing in this way, the General Assembly had curtailed the Court of Chancery jurisdiction in violation of the Delaware Constitution. They argued that the Delaware Constitution guarantees the Chancery Court the same or greater equity jurisdiction enjoyed by the High Court of Chancery of Great Britain at the time of separation from Britain, and since courts of equity at that time had the power to grant derivative standing to corporate stockholders “to prevent failures of justice,” the Delaware Constitution requires that the Chancery Court have jurisdiction to extend derivative standing where it is necessary to prevent complete failures of justice. The Court explained that derivative standing is a “judicially-created … creature of equity, ” and for that reason the Delaware General Corporation Law does not create derivative standing. Rather, section §327 (the only section of the DGCL addressing derivative standing) assumes the right of stockholders to sue derivatively but restricts the stockholders who can sue derivatively to those who owned their stock at the time of the alleged wrongful act or whose stock devolved upon them by operation of law from a stockholder who owned stock at that time. Therefore, the judicial extension of derivative standing to creditors in the corporate context was not an issue of statutory construction but rather an extension of a judicially-created equitable doctrine, consistent with the principles of equity, to address new circumstances. However, the statutes at issue in this case deal not with the corporate context but rather with limited liability companies, a form unknown at the time of separation. Therefore, the Court held that the Delaware Constitution did not preclude limitations on the scope of LLC derivative standing. Rather, courts adjudicating the rights, remedies and obligations associated with LLCs must look to the LLC Act, which alone created those rights, remedies and obligations. In the face of unambiguous statutory language expressly limiting derivative standing to members or assignees, the Chancery Court has no equitable power to override such limitations. The Court also noted that even if the Chancery Court had the jurisdiction to extend derivative standing to the plaintiffs, such jurisdiction should only be exercised absent an adequate remedy at law and where there is a threat of failure of justice. According to the Court, such remedy at law did exist and the paucity of remedies available to the plaintiffs was a function of their own contractual choices and did not carry a threat of failure of justice. The Court suggested potential terms that the plaintiffs might have bargained for, including a provision converting the creditors’ rights to that of an “assignee” in the event of insolvency, or a term that would have given the plaintiff management control of the LLC.  Link to Supreme Court opinion: http://courts.delaware.gov/opinions/download.aspx?ID=159960.  Link to Chancery Court opinion: http://courts.delaware.gov/opinions/download.aspx?ID=146170. 

Delaware Supreme Court Affirms Indemnification Decision Applying Traditional Laches Analysis. In IAC/Interactivecorp. V. O'Brien (No. 629, 2010, Del. Supr. August 11, 2011), the Delaware Supreme Court applied the doctrine of laches to a corporate indemnification claim, finding that the claim was not barred even though the analogous statute of limitations would have run. The case arose out of breach of fiduciary claims against Wesley O'Brien, CEO of Precision Response Corporation (PRC). In 2000, PRC was acquired by Defendant IAC/Interactivecorp., who assumed PRC's obligations to under its indemnification agreement with O'Brien. Two years later, IAC sued O'Brien for breach of fiduciary duties and fraudulent inducement in connection with a recently consummated merger, and PRC refused to advance O'Brien's legal fees. In 2005, an arbitration panel found that PRC was not entitled to recovery on its claims against O'Brien; in the meantime, O'Brien sued PRC in Florida for breach of contract based on the failure to indemnify and to advance fees. The litigation dragged on until 2008, when PRC filed for bankruptcy. O'Brien then sued IAC in Delaware Chancery Court for indemnification and advancement of his attorneys' fees and expenses in the arbitration, the Florida action and the Delaware action. The Court of Chancery granted O'Brien summary judgment, applying a traditional laches analysis rather than applying the analogous statute of limitations.

Sitting en banc, the Delaware Supreme Court affirmed. The Supreme Court cited the following factors that could bear on a laches analysis: (1) whether the plaintiff had been pursuing his claim, through litigation or otherwise, before the statute of limitations expired; (2) whether the delay in filing suit was attributable to a material and unforeseeable change in the parties' personal or financial circumstances; (3) whether the delay in filing suit was attributable to a legal determination in another jurisdiction; (4) to the extent to which the defendant was aware of, or participated in, any prior proceedings; and (5) whether, at the time this litigation was filed, there was a bona fide dispute as to the validity of the claim. Reviewing the facts in light of these factors, the Supreme Court first noted that O'Brien had promptly sought advancement against PRC and had filed suit in Florida before the arbitration was even concluded. In addition, IAC, the party ultimately responsible for PRC's indemnification and advancement obligations, had controlled the Florida litigation. The Court also noted that O'Brien had initially lost the Florida litigation at the trial court level, and that he could not in good faith proceed against IAC during the period, when the decision was on appeal, which lasted over a year. PRC's unexpected bankruptcy and the fact that the Florida courts held that O'Brien's claims were meritorious helped persuade the Court that the unusual circumstances of this case justified the Chancery Court's decision to disregard the statute of limitations, that O’Brien’s delay in filing suit against IAC was not unreasonable, and that IAC was not prejudiced by the delay. The Court also affirmed the Chancery Court's award of attorney's fees, including fees that included a 20% success fee and a contingent arrangement. The Court noted that 8 Del. C. §145(a) permitted indemnification for fees "actually and reasonably incurred" and that "the fact that the amount of the fee is not set until the result is obtained does not change the fact that the fee is incurred based on hours or work performed for the client."  Link to Supreme Court opinion: http://courts.delaware.gov/opinions/download.aspx?ID=158920.  Link to Chancery Court opinion:  http://courts.delaware.gov/opinions/download.aspx?ID=143910.

Delaware Supreme Court Reverses Chancery Court, Cites “Conceivability” Standard for 12(b)(6) Motions. In Central Mortgage Company v. Morgan Stanley Mortgage Capital Holdings LLC (No. 595, 2010, Del. Supr. Aug. 18, 2011), the Delaware Supreme Court, sitting en banc, reversed the Chancery Court's dismissal of claims alleging breach of contract and breach of the implied covenant of good faith and fair dealing. The case arose of out plaintiff Central Mortgage Company's (CMC) purchases of servicing rights on mortgage loans sold by Morgan Stanley. According to Morgan Stanley, these loans were to be sold to Fannie Mae and Freddie Mac, and CMC alleged that Morgan Stanley had made assurances that its due diligence satisfied the agencies' underwriting criteria. The Master Agreement between CMC and Morgan Stanley provided that within 60 days of discovery or notice to Morgan Stanley of a breach of representations or warranties that materially and adversely affected CMC's servicing rights related to any particular loan, Morgan Stanley was required to cure the breach, or, at CMC's option, repurchase CMC's servicing rights. After Morgan Stanley ceased its repurchases, CMC sued, alleging that Morgan Stanley had breached the Master Agreement and violated the covenant of good faith and fair dealing. The Chancery Court dismissed the breach of contract claim without prejudice, holding that CMC had failed to provide proper notice pursuant to the Master Agreement. According to the Chancery Court, the exhibits attached to CMC's complaint could not constitute notice, since they gave no chance to cure. In addition, forwarding agency files for non-complaint loans to Morgan Stanley did not constitute notice because CMC did not specify the representations or warranties allegedly breached. The Chancery Court also held that the implied covenant of good faith and fair dealing claim was duplicative of the contract claims and dismissed the claim with prejudice. 

In reversing the Chancery Court, the Delaware Supreme Court noted that the United States Supreme Court, in Ashcroft v. Iqbal (2009), had determined that to survive a motion to dismiss in a federal court, the complaint must contain sufficient factual matter that accepted as true would state a claim to relief that is plausible on its face. The Delaware Supreme Court emphasized that Delaware has not yet adopted the Iqbal standard and that to survive a motion to dismiss, the plaintiff must stated a claim that is "provable under any reasonably conceivable set of circumstances." Under this standard, CMC's allegations that it provided adequate notice were sufficient to survive Morgan Stanley's motion to dismiss. The Delaware Supreme Court also held that CMC's allegations that Morgan Stanley had made false representations regarding its due diligence practices did not serve as the basis for the breach of contract claim and could therefore serve as an independent basis for the implied covenant claim. Accordingly, the Chancery Court's dismissal with prejudice was reversed as well.  Link to Supreme Court opinion: http://courts.delaware.gov/opinions/download.aspx?ID=159390.  Link to Chancery Court opinion:  http://courts.delaware.gov/opinions/download.aspx?ID=142310.

Chancery Court Rules on Request for Expedited Proceedings. In In re Ness Technologies, Inc. Shareholders Litigation (C.A. No. 6569-VCN, Del. Ch. August 3, 2011), a class action suit to enjoin a proposed merger, the Delaware Chancery Court reviewed a motion to expedite proceedings. The plaintiffs, shareholders of Ness Technologies, Inc., alleged that the merger with Citi Venture Capital International (“CVCI”) was the product of a flawed sales process with inadequate disclosures. After noting that courts regularly grant requests to expedite proceedings, the Chancery Court reminded the parties that a plaintiff seeking such relief must articulate a sufficiently colorable claim and show a sufficient possibility of a threatened irreparable injury so as to justify the extra costs of an expedited preliminary injunction proceeding. Reviewing the plaintiffs’ claims, the Court first held that the allegation that one of the Ness Board members was conflicted because he was a nominee of CVCI was not colorable, since ; this Board Member had been excluded from the Special Committee designated to respond to the offer and had not been present for any negotiations or decisions regarding the sales process. The Court also held that without further details, allegations of unfair process based on the mere use of deal protection devices such as “no shop” and “no talk” provisions, a termination fee of 2.72% of the sale price, and a fiduciary out were not colorable. With respect to the plaintiffs’ disclosure claims, the Court found that the proxy soliciting approval of the merger of management projections, the financial advisors’ work, and the sale process satisfied the Board’s disclosure obligations contained fair summaries of these subjects. Noting that “shareholders are not entitled to a ‘play-by-play’ description of merger negotiations,” the Court held that the disclosure claims based on these summaries were not colorable. The Court did find sufficient specificity in the plaintiffs’ claims related to potential conflicts of interest by the financial advisors selected by the Special Committee and the Board to render a fairness decision. Although the proxy statement disclosed that the advisors had in the past provided services to affiliates of CVCI, the disclosures did not indicate the amount of business that the advisors had done and expected to do for CVCI or its affiliates. The Court therefore held that the plaintiffs’ price and process claim and disclosure claim based on these potential conflicts of interest were colorable and granted expedited discovery on the question of whether the advisors’ dealings with CVCI and its affiliates created conflicts of interest.  Link to Chancery Court Opinion: http://courts.delaware.gov/opinions/download.aspx?ID=159110