Court of Chancery Analyzes LLC Valuation Reports in Connection With Breach of Fiduciary Duty

By: Scott Waxman and Zack Sager

In Zachman v. Real Time Cloud Services, LLC, the Delaware Court of Chancery analyzed competing expert reports valuing a Delaware limited liability company in connection with a breach of fiduciary duty claim.  The Court also denied motions to exclude a valuation report and for sanctions relating to discovery abuses, and denied the Delaware limited liability company’s counterclaims for conversion and tortious interference with contract.

Plaintiff James Zachman and Defendant CBS Accounting Private, Limited, an Indian company (“CBS Accounting”), co-founded Intervenor-Defendant Real Time Data Services, LLC, a Delaware limited liability company (the “Company”), in 2006.  Defendant Sangeeta Chhabra founded CBS Accounting and co-managed the Company with Zachman.  In 2010, Zachman filed for bankruptcy.  As a result, Zachman ceased to be a member of the Company pursuant to Section 18-304 of the Delaware Limited Liability Company Act (the “LLC Act”), and became an assignee with the economic rights specified in Section 18-702(b) of the LLC Act.  Acting on the managerial control this termination gave her, in October 2012, Chhabra merged the Company with RTDS LLC (the “Merger”), converting Zachman’s interest as an assignee into cash in the amount of $0.  Chhabra arrived at $0 by first looking at the value Zachman assigned to his interest in his 2010 bankruptcy petition, which was $3,487.50.  Chhabra reduced this amount to $0 arguing that Zachman’s post-withdrawal actions caused financial harm to the Company.

Zachman eventually filed a complaint in the Court of Chancery bringing multiple counts against Defendants Real Time Cloud Services, LLC, Chhabra, and CBS Accounting.  The Court granted the Defendants’ motion for partial summary judgment on all counts except for Zachman’s claim for breach of fiduciary duty in connection with the loss of his interest in the Company pursuant to the Merger. 

Before addressing the breach of fiduciary duty claim, however, the Court addressed two predicate matters: (1) the Defendants’ motion in limine to exclude the Plaintiff’s valuation report with respect to the Company, and (2) the Defendants’ motion for sanctions relating to the Plaintiff’s discovery practice.  The Defendants sought to exclude the valuation report, arguing that it was inadmissible under Delaware Rule of Evidence 703.  Under Rule 703, an expert’s report must be based on “facts or data in the case that the expert has been made aware of.”  Where “the expert’s opinion is not based upon an understanding of the fundamental facts of the case,” it should be excluded.  The Defendants argued that the report was based on financial information that was, in turn, based on Zachman’s subjective conclusions regarding the Company’s expenses and income.  In addition, the report valued the Company as of May 2012, five months prior to the Merger.  Therefore, the Defendants argued, its factual basis was speculative.  The Court, however, found that the report illustrated a disagreement of the underlying facts, not a misunderstanding, and held that excluding the report was improper in that context. 

The Court then addressed the Defendants’ motion for sanctions against Zachman for his discovery abuses.  As relief, the Defendants asked the Court to bar Zachman’s expert from testifying.  The Court mandated that Zachman produce certain documents (such as personal tax returns and communications with customers of the Company), but Zachman failed to do so.  As such, the Court held that such failure warranted presumptions that these documents would have demonstrated facts favorable to the Defendants.  Because these factual presumptions sufficiently resolved the issues of Zachman’s failure to produce discovery, the Court denied the Defendants’ motion to bar testimony. 

With the predicate issues decided, the Court proceeded to analyze Zachman’s breach of fiduciary duty claim.  Default fiduciary duties apply to managers and managing members of a Delaware limited liability company unless the limited liability company agreement provides otherwise.  Here, the Court found that the Company’s limited liability company agreement did not alter the default fiduciary duties, which, therefore, applied to Chhabra.  Chhabra conceded that cashing out Zachman’s interest for $0 pursuant to the Merger breached her fiduciary duties.  According to the Court, the proper way to remedy this breach was to determine the fair value of Zachman’s interest at the time of the Merger and award him damages.

The parties submitted their valuation reports to the Court.  When evaluating valuation reports, the Court may select the most representative analysis and then make appropriate adjustments to the resulting valuation.  The Court found the Defendants’ valuation report more reliable for two reasons.  First, it valued Zachman’s interest at the time of the Merger (i.e., the time when Zachman’s interest was converted into $0) unlike Zachman’s report, which valued his interest five months prior to the Merger.  Second, the Defendants’ report used financial information from QuickBooks supplied by the Company, while Zachman’s report used financial information from QuickBooks he received from an accounting firm that Zachman engaged to “recreate” the Company’s financial statements from scratch based on source documents that were provided by Zachman.  According to the Court, Zachman had no credible basis for the financial figures supplied for his valuation report.  As such, the Court utilized the figures in the Defendants’ report as the basis for determining the value of Zachman’s interest at the time of the Merger.  The Court found that the Defendants’ report contained unduly conservative growth estimates for the Company and adjusted them up in order to assign a value to Zachman’s interest.

Lastly, the Court addressed the Company’s counterclaims against Zachman for conversion, violation of the Deceptive Trade Secret Act, and tortious interference with contract.  The Defendants sought to have any award from the Company’s counterclaims offset their liability owed for the fair value of Zachman’s interest.  The Court, however, found that the Defendants failed to establish any entitlement to damages and dismissed the counterclaims.

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