Delaware Court of Chancery Declines to Dismiss Claims for Breach of Contract and Breach of Fiduciary Duties

By Nick Froio and Zack Sager

In CMS Investment Holdings, LLC v. Castle, the Delaware Court of Chancery declined to dismiss claims for breach of contract, breach of fiduciary duties, aiding and abetting breach of fiduciary duties, and civil conspiracy, among others.

In Castle, the Plaintiff, CMS Investment Holdings, LLC, was a member of, and holder of Class A units in, RP Holdings Group, LLC, a Delaware limited liability company (the “Company”). The business of the Company (i.e., providing non-legal administrative services in connection with mortgage foreclosures) was created by the principal Defendants (i.e., five individuals who practiced law in Colorado and Arkansas). The Defendants held Class B and C units in the Company and ran the business in their various capacities as employees, officers, and managers of the Company. The Plaintiff’s complaint alleged that the Defendants, along with several of their affiliated entities, intentionally failed to make distributions to the Plaintiff, as a Class A unitholder, in favor of the Defendants in violation of the Company’s limited liability company agreement (the “LLC Agreement”). The Plaintiff also alleged that the Defendants purposefully took actions to block the Company from receiving much-needed debt refinancing, facilitated the Company‘s decline into insolvency, secretly negotiated with its creditors, and then, through their affiliated entities, purchased on favorable terms a major part of the Company’s business back from the Company in receivership.

The Plaintiff brought direct claims against the Defendants alleging (1) breach of the LLC Agreement and the implied contractual covenant of good faith and fair dealing, (2) breach of fiduciary duties, (3) aiding and abetting breaches of fiduciary duties, (4) civil conspiracy, and (5) violation of the Delaware Uniform Fraudulent Transfers Act. The Defendants filed a motion to dismiss for failing to state a claim upon which relief could be granted.

The Defendants first sought to dismiss the Plaintiff’s claims by arguing that such claims were derivative and that the Plaintiff could not bring them directly. According to the court, determining whether the claim of a member of a limited liability company is direct or derivative under Delaware law turns on the “Tooley” test, which consists of the following questions: (1) who suffered the alleged harm (the company or the suing member, individually); and (2) who would receive the benefit of any recovery or other remedy (the company or the suing member, individually)? If all of the members are harmed and would recover pro rata in proportion to their ownership of the Company solely because they are members, then the claim is derivative in nature.

The court found that the Plaintiff’s claims were more direct than derivative in nature. According to the court, the Plaintiff had direct claims for breach of contract. Specifically, the LLC Agreement provided that distributions were to be made to the Class A unitholders first, then to the Class B and C unitholders and the recipients of the Management Incentive Units. The Plaintiff alleged that certain Defendants used their positions within the Company to pay distributions to themselves (as Class B and C unitholders and recipients of Management Incentive Units) without making distributions to the Plaintiff, as a Class A unitholder, in breach of the LLC Agreement. Although the Company may have been harmed by such breach, the court held that the predominant harm fell on the Class A unitholders.

The court also found that the Plaintiff had direct claims for breach of fiduciary duties by alleging that the Defendants extracted economic value and voting power from the Class A unitholders and redistributed them to the Class B and C unitholders. Because the Class A unitholders would be the principal recipient of any recovery, the court found this claim to be more direct in nature.

The Court then addressed an argument by certain Defendants (the “Castle Defendants”) that they could not have breached the LLC Agreement because they were not parties thereto. One of the Castle Defendants, Lawrence Castle, however, was a manager on the Company’s Board of Managers. Pursuant to Section 18-101(7) of the Delaware Limited Liability Company Act, members and managers of a limited liability company are bound by the limited liability company agreement even if they do not sign it. As such, the court held that Lawrence Castle was bound by the LLC Agreement. The other Castle Defendant, Caren Castle, was not a manager of the Company, but allegedly held a high-level position in the Company and owned a substantial interest in the Company, indirectly, through various subsidiaries. The court cited the rule that in order to have an enforceable contract, the alleged parties thereto must objectively manifest an intent to be bound. Because nothing in the record demonstrated that Caren Castle intended to be bound to the LLC Agreement, the court dismissed the breach of contract claim against her. With respect to Lawrence Castle and the other Defendants bound by the LLC Agreement, the court found that the Plaintiff adequately pled claims for breach of contract because it was conceivable, based on Plaintiff’s allegations, that such Defendants participated in distributions contrary to the LLC Agreement.

The court then analyzed whether the Plaintiff adequately pled claims for breach of the implied contractual covenant of good faith and fair dealing. The court dismissed such claim against Caren Castle because only parties bound to a contract can breach the implied contractual covenant and Caren Castle was not a party to the LLC Agreement. With respect to the Defendants bound by the LLC Agreement, the court declined to dismiss the Plaintiff’s claim for breach of the implied contractual covenant because the Plaintiff alleged that these Defendants frustrated the unwritten, but implicit purpose of the Company, which was to provide non-legal administrative services in connection with mortgage foreclosures. According to the Plaintiff, the Defendants frustrated this purpose by providing these services themselves, separate from the Company, and not paying to the Company revenue generated therefrom.

The court then addressed the Plaintiff’s breach of fiduciary duty claims. In the absence of language in a limited liability company agreement to the contrary, the managers of a limited liability company owe traditional fiduciary duties of care and loyalty. Section 5.7 of the LLC Agreement provided that no manager of the Company would be liable to the Company or to any member except for acts or omissions attributable to gross negligence, willful misconduct, or knowing violation of the law. Because a breach of the duty of due care occurs when there is gross negligence in the absence of malevolent intent, the court found that the exculpatory language in the LLC Agreement did not diminish the default fiduciary duties owed by the managers of the Company.  In addition, the court also held that it was reasonably conceivable that high level officers of the Company and others who were not on the Board of Managers, but who were vested with discretionary power to manage the business of the Company, could have had more than an arm’s-length, contractual relationship with the members of the LLC, and thus could have owed fiduciary duties to the Company and its members. Based on the allegations of wrongdoing mentioned above, the court found that the Plaintiff adequately stated claims for breach of fiduciary duties against these Defendants. With respect to the Defendants who were not on the Company’s Board of Managers and did not otherwise exercise control over the Company’s business, the court dismissed the breach of fiduciary duty claims against them.

The court then addressed the Plaintiff’s claim for aiding and abetting breaches of fiduciary duties. According to the court, Delaware case law holds that aiding and abetting breach of fiduciary duty liability generally cannot attach to defendants who themselves owe fiduciary duties to the relevant plaintiff. This is because wrongful conduct on the part of a fiduciary would simply give rise to direct liability for a breach of the duties he owes, rather than secondary liability on the theory of aiding and abetting. Thus, the court dismissed the aiding and abetting claims against those Defendants who owed fiduciary duties to the Company and its members. The court, however, found it reasonably conceivable that, based on the Plaintiff’s allegations, the Defendants who did not owe fiduciary duties could be liable for aiding and abetting. This was, in part, because these Defendants were allegedly owned by and/or affiliated with the fiduciary Defendants and it was conceivable that they knowingly participated in the alleged breach of fiduciary duties.

The court also denied the Defendants’ motion to dismiss the claim that they participated in a civil conspiracy. Under Delaware law, to state a claim for civil conspiracy, a plaintiff must plead facts supporting (1) a meeting of the minds of the purported wrongdoers to commit an unlawful act, (2) an unlawful act in furtherance of the conspiracy, and (3) damages to the plaintiff.   Although the Plaintiff did not allege the existence of an explicit agreement among the Defendants to commit an unlawful act, the court found that it was reasonably inferable from the allegations that a meeting of the minds existed. The court also found that the Plaintiff satisfied the second and third prongs of the test in light of the fact that it adequately pled claims for breach of contract, breach of the implied contractual covenant of good faith and fair dealing, breach of fiduciary duty, and aiding and abetting breach of fiduciary duty.

In its opinion, the court also declined to dismiss any part of the Plaintiff’s Complaint under the doctrine of laches and declined to dismiss the Plaintiff’s claims for unjust enrichment and violation of the Delaware Uniform Fraudulent Transfers Act.CMSvCastle

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