Out of the money: breach of fiduciary duty claim survives motion to dismiss when the board approved an asset sale that left no consideration for the common unitholders
By: Scott E. Waxman and Chris Fry
In JJS, Ltd., et al., v. Steelpoint CP Holdings, LLC, et al., No. 2019-0072-KSJM (Del. Ch. 2019), the Delaware Court of Chancery (the “Court”) held that John Sarkisian, individually and on behalf of JJS, Ltd. and PPS Investors Ltd., L.P. (together, the “Plaintiffs”) successfully stated a claim for breach of fiduciary duty against a venture capital fund and its appointed board members in approving a transaction for the asset sale of Pro Performance Sports, LLC (the “Company”) where the common unitholders receive no compensation, the board members are under common ownership or employment with the venture capital fund, and one board member received an extraordinary severance package. The Court dismissed the Plaintiffs’ remaining claims, which turned on the interpretation of the voting rights provision of the limited liability company (“LLC”) agreement of the Company, finding that the operative language was not ambiguous and that a careful reading of the agreement would have given Plaintiffs notice of the voting rights mechanics.
Beginning in 2013, Steelpoint Capital Partners, LP (“Steelpoint”) invested cash into the Company for units (the “Investment”), ultimately acquiring Series A Preferred Units, Series B Preferred Units, Series C Preferred Units, and Series B Common Units through affiliates. In April 2018, the Company’s Board of Managers approved an asset sale for $40 million in cash (the “Transaction”), which left the common unitholders “out of the money.” The Company’s chief executive officer, along with three other board members, all Steelpoint appointees (collectively and together with Steelpoint, the “Defendants”), approved the Transaction. Two board members, representing common unitholders, voted against the Transaction, one of whom is a plaintiff, Sarkisian. One of the Defendants, Wiseman, was offered an allegedly extraordinary severance package of $600,000 a day before approving the Transaction.
The Company formalized the Investment in an original LLC agreement, which was twice amended, once in March 2016 and again in early 2017 (as amended, the “LLC Agreement”) to provide for Steelpoint’s acquisition of newly-created Series B Preferred Units and Series C Preferred Units. Despite the amendments to the operative section, the LLC Agreement consistently held that Major Member Decisions, including the Transaction, required the approval of the Series A Preferred Unitholder, as well as approval of the majority of the holders of the remaining series of preferred units voting together with the common unitholders. Other sections of the LLC Agreement, in contrast to Major Member Decisions, provide for unitholders voting as a separate class to approve other decisions.
Steelpoint, as sole Series A Preferred Unitholder, approved the Transaction. Steelpoint and affiliates, holding a majority of the Series B Preferred Units, Series C Preferred Units, and Series B Common Units, approved the Transaction by 55% of these units voting in common. Following this approval, the Plaintiffs demanded to inspect the books and records of the Company.
Shortly after the demand, Plaintiffs’ complaint asserted six causes of action regarding the Transaction, alleging that the Defendants breached the LLC Agreement and implied covenant of good faith and fair dealing regarding voting rights of the common unitholders and breached their fiduciary duties, as well as the Plaintiffs’ information rights. Plaintiffs asked for declaratory relief that the Transaction require the approval of the majority of the common unit holders, voting as a separate class, and reformation of the LLC Agreement to reflect such understanding of the voting rights. The Defendants filed a motion to dismiss all causes of action, on which the Court is ruling in the instant action.
The Court, applying standard canons of contractual interpretation, easily dismissed the causes of action related to the breach of the LLC Agreement, as the LLC Agreement was not ambiguous, other sections did include separate class voting, and the operative section had been amended and approved more than once. Similarly, the Court dismissed the claims related to the implied covenant of good faith and fair dealing because the covenant “seeks to enforce the parties’ contractual bargain by implying only those terms that the parties would have agreed to during their original negotiations if they had thought to address them.” As the LLC Agreement clearly addressed the instant circumstances, the covenant does not apply.
Reformation was likewise dismissed, as the Court held that the “Defendants were ‘entitled to expect that [Plaintiffs] would read the [agreement] with care.’” The Court also dismissed the cause of action related to the breach of information rights, because the commencement of litigation severely limits the circumstances in which equity holders may enforce inspection rights under Delaware law.
The Court upheld the claim for breach of fiduciary duty, surviving the motion to dismiss. In determining whether to apply the business judgment rule to the Transaction, the Court found that the Plaintiffs successfully rebutted the presumption that the Transaction “’was taken by a board majority comprised of disinterested and independent directors.’” In reaching this conclusion, the Court found it reasonable that Defendants could be interested in the Transaction due to the following. Wiseman could be interested due to the allegedly extraordinary severance package and its timing. Steelpoint’s liquidation preference could give it a “divergent interest” from the common unitholders, and especially at the pleadings stage, the Court found it reasonable to infer such divergent interest in the Transaction as structured, with no consideration for the common unitholders. Finally, the Court found it reasonable that the remaining Defendants, the other Steelpoint-appointed board members, could also be interested because each one is also an owner, officer, and/or employee of an entity that owns the preferred stock, Steelpoint. The Court held that such ownership or employment relationship with such entity creates enough reasonable inference of interest to survive a motion to dismiss. Accordingly, the Court held that Plaintiffs successfully stated a claim for breach of fiduciary duty.