Not quite instantaneous, Holmesian “Bad Men” can win by knowing the law: Plaintiffs who tried to preserve direct and derivative claims in a settlement agreement failed to realize that they had already bargained them away

By: Scott E. Waxman and Chris Fry

In Urdan v. WR Capital Partners, LLC, C.A. No. 2018-0343-JTL (Del. Ch. 2019), the Delaware Court of Chancery (the “Court”) held that Urban and Woodward (the “Plaintiffs”) lost the ability to assert their derivative and direct claims by failing to properly preserve their claims in the stock repurchase agreements and settlement agreement among the Plaintiffs, Energy Efficient Equity, Inc. (the “Company”), and the private equity group that essentially pushed the Plaintiffs out of the Company, WR Capital Partners, LLC, et al., (the “PE Firm”).  The Court dismissed the Plaintiffs’ remaining claims for fraud, as the Plaintiffs could not reasonably rely on puffery, and unjust enrichment, as this is more properly a derivative claim dismissed with the direct and derivative claims above.

Urdan co-founded the Company in 2014 to finance clean energy improvements in the property-assessed, clean-energy (PACE) financing industry.  The Plaintiffs and the other co-founder and CEO, Kurka, owned 100% of the equity of the Company. They were approached by the PE Firm to “partner” with the Plaintiffs to provide financing, open up additional avenues of financing, and provide management expertise.

The parties negotiated a revolving credit line of $5 million with the PE Firm (through a subsidiary) holding an option, in its sole discretion, to increase the credit facility by $3 million in exchange for a warrant to purchase additional shares (the “Credit Line Increase”).  Under the terms of the loan agreement, closed in May 2016, the Company expanded its board to five members, and the PE Firm received the right to appoint two members of the board.  The PE Firm also negotiated for a negative covenant restricting the rights of the Company to seek additional financing or engage in significant corporate transactions without the consent of the PE Firm and negotiated for an event of default where the credit line would be accelerated in the event of either Urdan’s or Kurka’s being terminated for cause pursuant to their employment agreements.

In March 2017, the PE Firm sent a “rules of the road” letter to Kurka and conditioned additional draws under the credit line on Kurka’s executing the letter.  Less than a month later, the PE Firm unilaterally terminated Kurka without a board vote, and Kurka lost his board seat as a result of the termination.  The PE Firm installed its own candidate, Knyal, as CEO, without complying with the Company’s bylaws, with the PE Firm causing the Company to grant Knyal a 12% equity stake in the Company.  The board was now deadlocked with the Plaintiffs and the PE firm each holding two seats.  However, controlling the only source of capital infusion and installing Knyal as CEO, the PE Firm had effectively wrestled practical control of the Company from the Plaintiffs.

By June 2017, the Company faced a capital crisis.  The Plaintiffs attempted to secure the Credit Line Increase with the PE Firm. The PE Firm eschewed the option for the Credit Line Increase, instead choosing to negotiate for additional consideration.  The PE Firm would provide the additional $3 million for a warrant valued at 2249% more than the warrant negotiated under the loan agreement and an additional (and majority) seat on the board.  If the Plaintiffs did not accept these terms, the PE Firm threatened to declare an event of default under the loan agreement for the termination of Kurka.  As the Court would later elucidate, the Plaintiffs failed to understand the mechanics of the option for the Credit Line Increase. The option was at the sole discretion of the PE Firm, and the PE Firm could choose to negotiate for further consideration.

Facing a possible total loss of investment, the Plaintiffs accepted the financing. Following the financing, the PE Firm fired outside counsel and later terminated Urdan in January of 2018, effective May 31, 2018. The Plaintiffs filed the lawsuit in May 2018 alleging multiple breaches of fiduciary duty, fraudulent inducement, fraudulent concealment, breach of the loan agreement for renegotiating the Credit Line Increase, and unjust enrichment.

While the lawsuit was pending in August 2018, the Company completed a recapitalization and used the proceeds to repurchase the Plaintiffs’ shares.  Each Plaintiff and the Company entered into a repurchase agreement in which each Plaintiff sold “all right, title, and interest in and to the [shares], free and clear of any mortgage, pledge, lien, charge, security interest, claim, or other encumbrance,” and the Plaintiffs, the Company, and the PE Firm, among others, entered into a settlement agreement settling certain claims, with a carve out for the direct and derivative claims asserted in the Plaintiffs’ lawsuit.  The PE Firm also agreed to waive any defenses related to the stock repurchase, including lack of standing now that the Plaintiffs no longer held shares in the Company.

Under the terms of the repurchase agreements and settlement agreement, the settlement agreement was conditioned upon the closing of the repurchase agreements. While the settlement agreement was defined in the recitals, the repurchase agreements did not specifically incorporate by reference the terms of the settlement agreement and contained an integration clause indicating that the terms of the repurchase agreement controlled in the event of a conflict with the settlement agreement. The repurchase agreements did not contain a carve out for the Plaintiffs’ claims in the lawsuit.

Under Delaware law, derivative and direct claims are rights bundled with the shares’ property rights. Plaintiffs who sell their shares without specifically reserving such rights lose standing to assert those claims, as those claims pass to the buyer.  In this case, the Court held that the Plaintiffs’ claims passed to the Company under the terms of the repurchase agreements.  In selling “all right, title, and interest,” the Plaintiffs neither expressly reserved their claims, conditioned the closing of the repurchase agreements on the settlement agreement, nor incorporated the settlement agreement into the repurchase agreements.

Rather, the Court found that the repurchase agreements closed the “microsecond” before the settlement agreement by operation of law, as the closing of the repurchase agreements was a condition of the settlement agreement. Accordingly, any shareholder rights not expressly reserved in the repurchase agreements passed to the Company, including any direct or derivative claims. The Court held that the settlement agreement did preserve any claims that the Plaintiffs expressly reserved in the repurchase agreements, which in this case was none of them. “The plaintiffs could have contracted not to sell all of the Repurchased Securities and to retain certain rights associated with their shares. But they did not do that. They sold all of their shares, and their right to assert direct and derivative claims passed to the buyer.”

The Plaintiffs attempted to fall back on the waiver of defenses in the settlement agreement.  However, the Court held that the Plaintiffs “lacked any legally cognizable interest in the claims,” as the Plaintiffs had already voluntarily sold their shares. Accordingly, “[t]he plaintiffs cannot rely on the Waiver Provision to convert non-justiciable claims into justiciable ones.” With the Court’s dismissal of the fraud and unjust enrichment claims, the Plaintiffs had effectively bargained away their claims in the repurchase agreements and had no rights left to preserve under the settlement agreement.


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