Delaware Law On Derivative Actions And Fiduciary Duties

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[author: Mack Sperling]

If you are a derivative action plaintiff, and you make a demand on an LLC to take action which is then considered and rejected, may you still pursue your claims? Judge Murphy answered that question, and others relating to derivative actions under Delaware law in this week's opinion in Scott v. Lackey, 2012 NCBC 58.

By the way, the reason that I am writing today about Delaware law, instead of North Carolina law, is that the entities involved in the Scott case were formed in Delaware, so Judge Murphy ruled that Delaware law controlled.

Derivative Action After Rejected Demand

In North Carolina, the answer is in G.S. §57C-8-01. If the Court appoints a committee of "two or more disinterested managers, directors, or other disinterested persons, acceptable to the limited liability company, to determine whether it is in the best interest of the limited liability company to pursue a particular legal right or remedy." Then, if the committee determines that it would not be in the best interests of the LLC to pursue the claim, the Court can dismiss it.

In Delaware, the answer is a bit more complicated, as borne out by the Business Court's decision  in the Scott case.

Delaware law in this niche implicates the business judgment rule. Three issues arise:

'(1) whether the [managers] acted independently and not self interestedly; (2) whether the [managers] reasonably investigated the basis for the proposed litigation; and (3) whether the [managers] refused to act in good faith. Seaford Funding Ltd. P’ship v. M & M Assocs. II, 672 A.2d 66, 70 (Del. Ch. 1995) (citing Spiegel, 571 A.2d at 777).

Op. ¶52.

in Delaware, by making a demand, the derivative plaintiff "tacitly concedes the independence of a majority of the board to respond." Op. ¶52. But Delaware law does not imply a concession that the managers of an LLC will act in a disinterested way in considering a demand. Op. ¶53.

Judge Murphy found a "reasonable doubt" as to whether two of the managers had acted in good faith in responding to the demand. He noted that they had refused to meet with the Plaintiff to discuss his concerns. He also observed that they stood to benefit directly from the challenged transactions, and he denied the Motion to Dismiss the derivative claims.

Adequacy Of Derivative Plaintiff

A Delaware derivative Plaintiff "must be qualified to serve in a fiduciary capacity as a representative of a class, whose interest is dependent upon the representative's adequate and fair prosecution." Op. ¶93.

The Defendants in the Scott case said that Scott was an inadequate Plaintiff because he had a personal interest in gaining control of the LLC.

Judge Murphy disagreed, holding that "selfish motives alone will not mandate Plaintiff's disqualification as an inadequate representative." Op. ¶96. He added that "it is hardly unusual for derivative plaintiffs to have their own interests in mind when bringing a derivative action." Id.

The Defendants pointed to a defamation claim lodged against them by the Plaintiff as evidence of Plaintiff's vindictiveness towards them. Judge Murphy shot down that argument as well, again looking to Delaware law:

absent some concrete fact revealing a conflict between Plaintiff and BHCM, 'amorphous hostile feelings against defendants [are] not in [themselves] relevant.' Emerald Partners, 564 A.2d at 677 (quoting Vanderbilt v. Geo-Energy Ltd., 590 F. Supp. 999, 1001 (E.D. Pa. 1984)).

Op. ¶99.

Defendants also argued that the Plaintiff's derivative action did not have the support of other members of the LLC. That too was an insufficient argument  Judge Murphy observed that "[a] derivative claim may be maintained . . . without the support of a majority or ownership or even the support of the entire minority."  Op. ¶100.

Breach of Fiduciary Duty

Judge Murphy found that the Defendants owed a fiduciary duty to the Plaintiff, stating that "unless otherwise stated in the LLC agreement, 'the member-managers of a Delaware limited liability compan[y] owe traditional fiduciary duties to the LLC and its members." Op. ¶69.

For a long time, that appeared to be the law of Delaware, but recent developments show that it is not. In Gatz Properties LLC v. Auriga Capital Corp., No. 148, 2012 (Del. Supr. Nov. 7, 2012), the Delaware Supreme Court said that the issue of a "default fiduciary duty" remained an "open question,"

It chastised the Chancey Court Judge for saying otherwise, stating

We feel compelled to address this dictum 'because it could be misinterpreted in future cases as a correct rule of law,' when in fact the question remains open. Gotham Partners, L.P. v. Hallwood Realty Partners, L.P., 817 A.2d 160, 167 (Del. 2002).

Gatz, supra, at n.62 (emphasis added).

Would it have made a difference to Judge Murphy's opinion if Delaware law had been clear on the fiduciary duties of managers? Probably not, as it seems inevitable that the Delaware Supreme Court will reach the conclusion that managers have a fiduciary duty to their LLC. The North Carolina Court of Appeals  ruled three years ago that LLC managers owe such a fiduciary duty to the LLC, in Kaplan v. O.K. Technologies, LLC.

I wrote about the differences between Delaware and North Carolina on the point of LLCs and fiduciary duty in April 2009.

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If you are wondering what I want for Christmas, it would be a decision from the North Carolina Business Court on an open question of North Carolina's corporate law to write about. I'm tired of writing about Delaware law.