Delaware Court Of Chancery Allows Direct Claims For Breach Of Contract And Fraud To Proceed, Even After Dismissing Related Derivative Claims
In MKE Holdings, Ltd. and David Bergevin v. Kevin Schwartz, et al. and Verdesian Life Sciences, LLC, C.A. No. 2018-0729-SG (Del. Ch. Jan. 29, 2020), the Delaware Court of Chancery allowed direct claims for breach of contract and fraud in connection with an equity financing to survive a motion to dismiss, even after having previously dismissed the related derivative claims.
MKE Holdings, Ltd. and David Bergevin (collectively, the “Plaintiffs”) were members of Verdesian Life Sciences, LLC (“Verdesian” or the “Company”). Verdesian was managed and controlled by an eight-member Board of Managers (the “Managers”), which consisted exclusively of officers and employees of Paine Schwartz Partners, LLC (“Paine”). At the time, Paine was Verdesian’s majority member and Paine affiliates were empowered to appoint each Manager. According to the Plaintiffs, in connection with soliciting new equity financing from Verdesian’s members (including the Plaintiffs) to finance an acquisition, the Managers allegedly failed to disclose all material financial information. The Plaintiffs alleged that, due to this and subsequent acquisitions, other purportedly deficient management practices, and an arrangement in which Paine received a management service fee based on Verdesian’s financial performance and transaction fees on certain Verdesian acquisitions, Verdesian’s operating performance declined and its credit rating was downgraded.
Initially, the Plaintiffs filed a direct and derivative suit against Verdesian, Paine, and individual Managers, alleging breach of contract under Verdesian’s operating agreement, breach of fiduciary duty, fraud, and aiding and abetting. In a prior decision, the Court relied on exculpatory language in the Company’s operating agreement to dismiss the Plaintiffs’ derivative claims. In this decision, the Court considered the Plaintiffs’ remaining direct claims — that is, breach of Verdesian’s operating agreement, fraud, and aiding and abetting.
With respect to the Plaintiffs’ first direct claim for breach of contract, the Court declined to grant Verdesian’s motion to dismiss and allowed such claim to proceed. The Court noted that, under the applicable standard of care in the operating agreement, a Manager is obligated to act “in good faith, in a manner he reasonably believes to be in or not opposed to the best interests of the Company, and with the care that an ordinarily prudent person in a similar position would use under similar circumstances.” The Court also noted that the operating agreement effectively exculpated the Managers for conflicted, negligent and other detrimental decisions, so long as such decisions were taken in good faith. As a result, in order to be liable for breach of the operating agreement, a Manager must have acted in bad faith. In this context, the Court concluded that the Managers (i) failed to disclose all material financial information in connection with soliciting an equity contribution from the Plaintiffs to fund the relevant acquisition and (ii) misrepresented the acquired company’s future prospects and performance. In other words, the Court stated it was not unreasonable to infer, at the pleading stage, that the Company withheld certain information “on the basis of bad faith to solicit equity contributions from the Plaintiffs and consequently receive transaction and management service fees for the transaction while decreasing the amount that the Managers had to borrow.” Accordingly, the Court allowed the Plaintiffs’ direct claim for breach of contract to survive a motion to dismiss.
With respect to the Plaintiffs’ second direct claim alleging fraud and aiding and abetting, the Court also declined to grant Verdesian’s motion to dismiss. Within the context of common law fraud, the Court found that the Plaintiffs had pled with sufficient particularity that the Managers actively concealed facts that prevented the Plaintiffs from discovering them (i.e., fraudulent concealment). In the Court’s view, the Managers had elected not to disclose certain material financial information and thus failed to provide an accurate portrait of the acquired company’s financial performance. Further, the Court declined to dismiss the Plaintiffs’ claim that Paine, as the majority equity holder of Verdesian, aided and abetted the fraud committed by the Managers.