Chancery Court Declines to Expand Gentile Doctrine

By: Scott Waxman and Doug Logan

In Dr. Thomas Markusic et al. v. Michael Blum et al. memorandum opinion 200818, the Delaware Chancery Court (the “Court”) declined to extend the Gentile doctrine. In so doing, the Court held that the counterclaims attempting to rely on it had to be dismissed.

Firefly Space Systems, Inc. (“Original Firefly”) was an aerospace startup founded by Michael Blum, Patrick Joseph King, and Thomas Markusic in late 2013 with the aim of launching small-load rockets into orbit. Counterclaim-Plaintiffs Blum, King, Lauren McCollum, Steven Begleiter, Green Desert N.V., Swing Investments BVBA, Bright Success Capital Ltd., and Wunderkind Space Ltd. (collectively, “Original Firefly Investors”) each owned stock in Original Firefly, with Markusic in the role of CEO and sole board member of Original Firefly at all relevant times.

In June 2015, Original Firefly raised approximately $1 million in the form of a convertible note (the “Space Florida Note”) from Space Florida, the aerospace economic development agency of the State of Florida. The Space Florida Note had senior status to all other Original Firefly debt, and it could not be assigned to another lender without Original Firefly’s consent. In October 2016, Original Firefly raised another $1.5 million in debt financing (the “FITA Note”) from FITA, Inc., an entity controlled by one of Original Firefly’s investors. The FITA Note served as a bridge loan while Original Firefly worked to conclude its Series A funding round. The FITA Note was senior to the Original Firefly Investors’ own investments in Original Firefly.

In October 2016, Original Firefly entered into a confidentiality agreement (the “Confidentiality Agreement”) with another prospective investor, Noosphere Venture Partners, LP. (“Noosphere”). Noosphere’s CEO, Maxym Polyakov, then visited Original Firefly’s facilities in Texas, and, with his partner Mark Watt, summarized their proposed next steps for Noosphere’s proposed investment in Original Firefly and negotiated with Markusic over the next month. In November 2016, Noosphere offered a proposed term sheet for another convertible note financing. The Original Firefly Investors and Markusic believed this proposal substantially undervalued their Original Firefly equity. Markusic told the Original Firefly Investors that he would continue negotiating with Noosphere. By December 2016, Noosphere changed its approach from negotiating a new convertible note financing to acquiring portions of Original Firefly’s existing debt. The Original Firefly Investors alleged that Markusic encouraged this change of plans, helping Polyakov, Watt, and Noosphere to identify and target outstanding debt held by creditors that would be ripe for foreclosure and, further, that at the same time Markusic began negotiating an employment agreement with Noosphere.

In January 2017, Polyakov, Watt, and Noosphere revived their proposal to acquire Original Firefly’s existing senior debt. Markusic supported the revived proposal. Later that month, Markusic announced he was going to travel to Ukraine to determine what capabilities Polyakov’s companies had and to solicit further strategic investment and, at the same time, Polyakov incorporated a company named EOS in Delaware.

In February 2017, EOS purchased the FITA Note. The Original Firefly Investors actively voiced their disapproval and concerns after becoming aware of this transaction. EOS also purchased the Space Florida Note. The Original Firefly Investors alleged that Markusic approved the assignment of the Space Florida Note to EOS in his capacity as the sole director of Original Firefly. Markusic did not obtain the approval of the Original Firefly Investors or any other Original Firefly stockholders, which the Original Firefly Investors alleged was required.

EOS foreclosed on both loans shortly after acquiring the FITA Note and Space Florida Note. The Original Firefly Investors then demanded that Markusic cause Original Firefly to file for bankruptcy voluntarily because they wanted a bankruptcy trustee to manage the sale of Original Firefly’s assets and protect Original Firefly from the selective foreclosure process. Instead, Markusic scheduled a foreclosure auction of Original Firefly’s assets for mid-March 2017. The Original Firefly Investors notified media outlets and potential bidders, but the auction was not widely publicized and EOS carried out the auction and also purchased every asset up for sale, including Original Firefly’s intellectual property. EOS purchased Original Firefly’s remaining assets after Original Firefly filed for bankruptcy.

In late March 2017, EOS changed its name to Firefly Aerospace, Inc. (“New Firefly”) and appointed Markusic as its CEO. In his new role, Markusic’s compensation and equity interests were far greater than his interests in Original Firefly. Two years later, in September 2019, New Firefly and its management and investors, Markusic, Polyakov, and Noosphere, filed litigation seeking a declaratory judgment that Markusic did not breach his fiduciary duties and that Polyakov, Noosphere, and New Firefly did not aid and abet any alleged breaches. When answering the complaint, the Original Firefly Investors asserted counterclaims against the plaintiffs and Watt (collectively, the “New Firefly Contingent”). The New Firefly Contingent moved to dismiss the Counterclaims.

The Original Firefly Investors asserted five causes of action, referred to as Counterclaims I through V:

    I.   Markusic breached his fiduciary duty of loyalty.

   II.   Polyakov, Watt, Noosphere, and New Firefly aided and abetted in Markusic’s breaches of fiduciary duty.

  III.   Noosphere breached the Confidentiality Agreement by misusing Original Firefly’s confidential information to engineer a takeover of Original Firefly rather than to invest in Original Firefly.

  IV.   Markusic, Polyakov, Watt, and New Firefly tortiously interfered with the Confidentiality Agreement by causing Noosphere’s breach.

   V.   Polyakov, Watt, Noosphere, and New Firefly tortiously interfered with the Original Firefly Investors’ prospective economic advantage by disrupting their business relationship with Original Firefly.

The New Firefly Contingent moved to dismiss the counterclaims, contending that Counterclaims I, II, III, and IV were derivative—that is, the claims were not assigned to the Original Firefly Investors by the bankruptcy court, and thus, the Original Firefly Investors lacked standing. They also contended that Counterclaim V failed to state a claim upon which relief could be granted.

The Original Firefly Investors responded that their fiduciary duty claims in Counterclaims I and II were direct and that they stated a claim upon which relief can be granted. They conceded that Counts III and IV were derivative but argue that the bankruptcy did not affect those claims and that they had adequately pleaded demand futility. Finally, they argued that Count V stated a claim upon which relief could be granted.

The Court dismissed Counterclaims I and II because they were derivative, and the Original Firefly Investors did not have the authority to bring them on behalf of Original Firefly. In Counterclaim I, the Original Firefly Investors alleged that Markusic, as CEO, owed fiduciary duties and that he breached those duties by using his control over the Original Firefly’s assets to make a deal for himself and Polyakov, Watt, and Noosphere. In Counterclaim II, Counterclaim-Plaintiffs alleged that Polyakov, Watt, Noosphere, and New Firefly aided and abetted Markusic’s alleged breaches in Counterclaim I. Further, the Original Firefly Investors argued that their claims were direct in nature because they suffered a special injury distinct from that suffered by Original Firefly or the stockholder group as a whole. The Original Firefly Investors argued under the Court’s Gentile paradigm that Markusic “effectively controlled” Original Firefly and that he exploited his position for personal gain.

The Court found the Original Firefly Investors’ reliance on Gentile misplaced. The Gentile doctrine seeks to remedy harms that arise when a controlling stockholder, with sufficient power to manipulate the corporate processes, engineers a dilutive transaction whereby that stockholder receives an exclusive benefit of increased equity ownership and voting power for inadequate consideration. Since Gentile, the Court has narrowly construed the doctrine, holding that for Gentile doctrine to apply both economic and voting power must be improperly transferred. The Court found that the facts of this case did not fit the Gentile doctrine mold. That is, The Original Firefly Investors alleged that Markusic approved transactions that depleted the economic value of Original Firefly for Markusic’s own benefit, but they did not allege any dilution or loss of voting rights.

Further, upon commencement of Chapter 7 bankruptcy proceedings, derivative claims become the property of the bankruptcy estate and are subject to bankruptcy court. Claims subject to the control of the bankruptcy trustee must be dismissed unless the plaintiffs are able to demonstrate authority to proceed in the trustee’s place. This delegation of authority requires: a) that the bankruptcy trustee has affirmatively assigned or abandoned the claims to the plaintiffs and b) the bankruptcy court approved plaintiffs’ prosecution of the claims in this Court. The Original Firefly Investors did not plead that the bankruptcy trustee assigned them the authority to bring Counterclaims I and II nor that the bankruptcy court approved any such assignment.

In Counterclaim III, the Original Firefly Investors alleged that Noosphere misused Original Firefly’s confidential information thereby breaching the Confidentiality Agreement. In Counterclaim IV, the Original Firefly Investors alleged that Markusic, Polyakov, Watt, and New Firefly tortiously interfered with the Confidentiality Agreement. Counterclaims III and IV were derivative in nature, and these claims were dismissed because the Original Firefly Investors neither alleged that they were assigned the authority to bring these claims nor that the bankruptcy trustee approved any such assignment.           

Counterclaim V, was dismissed by the Court because the Original Firefly Investors did not identify a party who was prepared to enter into a business relationship with them as stockholders of Original Firefly. Their conclusory allegation that they had an existing and prospective business with Original Firefly did not suffice to fulfill the requirements of a tortious interference claim.

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