The distinction between direct and derivative claims pervades business divorce litigation. Whether a dissident owner’s claim against his or her co-owners is a direct claim (one that the owner can assert in their individual capacity) or a derivative one (one that seeks to redress injury to, and therefore must be asserted on behalf of the business) factors into almost every claim we litigate, and it is one of the most common grounds for a pre-answer motion to dismiss, as this post demonstrates.

Given the choice, most owners would prefer to assert their claims directly. Derivative claims beget a host of prerequisites and considerations: has the pre-suit demand requirement been complied with? Can the corporation take the litigation out of a shareholder’s hands by appointing a special litigation committee? If successful on the claims, what assurances does the shareholder have that the corporation’s recovery will be passed on to the shareholders?

For that reason, we sometimes see shareholders or LLC members utilize artful pleading strategies to cast their claims as direct ones. But the Tooley test—the standard, under both Delaware and New York law to determine whether a claim is direct or derivative—is a good one. By considering (1) who suffered the alleged harm (the corporation or the stockholders); and (2) who would receive the benefit of any recovery or other remedy (the corporation or the stockholders individually), Courts and attorneys usually can spot the differences between a direct claim and a derivative one.

A recent decision from the Southern District of New York, Miller v Brightstar Asia, 20-CV-4849 (SDNY Sept 11, 2023) considers a shareholder’s reliance on the implied covenant of good faith and fair dealing inherent in the corporation’s shareholders agreement in an attempt to plead what otherwise would be derivative claims as direct ones.

Harvestar, Brightstar, and the Shareholders Agreement.

Tyler Miller and his business partner, Omar Elmi, founded Harvestar, a “Hong Kong private company limited by shares” and governed by Delaware law, to enter the business of refurbishing pre-owned mobile phones. From its founding until 2018, Miller and Elmi each owned 50% of Harvestar’s outstanding shares. In 2018, Brightstar—one of Harvestar’s biggest customers and a seller of refurbished phones—purchased a 51% controlling stock interest in Harvestar.

In connection with Brightstar’s acquisition, Brightstar, Miller, and Elmi entered into a Shareholders Agreement, which had several features relevant here:

• Put and Call Rights. Sections 10 and 11 of the Shareholders Agreement gave Miller and Elmi certain put and call rights. With respect to the call option—the right to purchase additional shares—the Shareholders Agreement provided that the purchase price for the call shares hinged on a valuation formula incorporating both the number of devices that Harvestar refurbished in the prior year, and Harvestar’s then-indebtedness.

• Fiduciary Duty Waiver. Section 29 of the Shareholders Agreement provided that “to the maximum extent permitted by applicable law,” no shareholder “shall owe any duty (including any fiduciary duty) to [Harvestar] or to any other Shareholder . . .”

• Expressing the Implied Covenant. Section 29 went on to state that as to the implied covenant of good faith and fair dealing, the “parties hereto acknowledge and agree that any Shareholder acting in accordance with this [Shareholders] Agreement shall (a) be deemed to be acting in compliance with such implied contractual covenant.”

Finally, Section 14 of the Shareholders Agreement set forth the limits under which Brightstar could utilize Harvestar’s services for its own affiliates: “Any transaction between [Harvestar], on the one hand, and [Brightstar], on the other hand, will be on terms no less favorable to [Harvestar] than would be obtainable in a comparable arm’s length transaction.”

Brightstar’s Alleged Mismanagement.

According to Miller, almost immediately after obtaining control of the corporation, Brightstar mismanaged Harvestar to the benefit of itself and its affiliates. Among other things, Brightstar “placed millions of dollars in intercompany loans and other obligations on Harvestar’s balance sheet,” “cancelled all repair services that Harvestar provides to its [non-Brightstar] customers,” and caused Harvestar to provide its refurbishing services at $50 less per device than Harvestar could get in an arm’s-length transaction.

In June 2020, Miller filed a federal complaint asserting direct claims against Brightstar for its mismanagement of Harvestar and breach of Section 14 of the Shareholders Agreement, causing the diminution in the value of Harvestar. Miller alleged that Brightstar breached both (i) Section 14 of the Shareholders Agreement by causing Harvestar to provide services to Brightstar on less-than-arm’s-length terms, and (ii) the implied covenant of good faith and fair dealing, by increasing debt and dramatically downsizing Harvestar’s production, and thus impairing the value of Harvestar to the detriment of his options rights.

Direct or Derivative?

Based on the summary above, how would you characterize Miller’s claims?

You’d be forgiven if you answered that both were derivative. The District Court first dismissed Miller’s complaint on the grounds that he had improperly pled these claims directly when they should have been pled derivatively. The District Court held that based on Section 14 of the Shareholders Agreement, “any alleged contractual duty belongs to Harvestar and not Plaintiff individually.” That included, according to the district court, the implied covenant of good faith and fair dealing.

Due to His Options Rights, Miller Can State a Direct Claim for Breach of the Implied Covenant of Good Faith and Fair Dealing.

In an order dated August 3, 2022, the Second Circuit reversed the District Court’s dismissal of Miller’s implied covenant of good faith and fair dealing claim. The Court reasoned that because Miller had put and call rights, and because the price of those option rights turned in part on Harvestar’s debt and the number of devices it refurbished, Brightstar’s implied covenant of good faith and fair dealing included an obligation not to engage in “arbitrary or unreasonable conduct” to depress those inputs and destroy the value of Miller’s option rights.

Moreover, Miller could state his implied covenant claim directly, rather than derivatively, the Second Circuit held, because Miller held the option rights as a shareholder, and Brightstar’s alleged misconduct destroyed the value of those option rights:

Count III alleges that ‘Brightstar Asia has caused plaintiff’s ‘put’ rights pursuant to Paragraph 10 of the Shareholders Agreement and plaintiff’s ‘call’ rights pursuant to Paragraph 11 of the Shareholders Agreement to be rendered worthless.’ That conduct, according to the complaint, violated the ‘implied covenant’ that ‘required, inter alia, that [Brightstar] refrain from engaging in, or causing Harvestar to engage in, conflict[ed] transactions to the detriment of Harvestar or plaintiff.’ Because Miller alleges a violation of an implied contractual duty owed to himself, he may bring Count III in a direct suit.”

Does the Implied Covenant Claim Survive the Limiting Language?

On remand, with Miller’s breach of the implied covenant theory as the only surviving claim, Brightstar again moved to dismiss for failure to state a claim. This time, Brightstar argued that Miller’s claim fails due to Section 29 of the Shareholders Agreement, which states that “any Shareholder acting in accordance with this [Shareholders] Agreement shall (a) be deemed to be acting in compliance with [the implied covenant of good faith and fair dealing].” The existence of Section 29, Brightstar argued, meant that Miller could not show a breach of the implied covenant without showing that Brightstar had breached an express term of the Shareholders Agreement.

In a report and recommendation dated September 11, 2023, United States Magistrate Judge James L. Cott held that Miller adequately pled his claim for breach of the implied duty of good faith and fair dealing. Citing the considerable body of Delaware caselaw holding that the implied covenant of good faith and fair dealing cannot be waived, the Court rejected Brightstar’s argument that Section 29 made the implied duty coterminous with the express language of the Shareholders Agreement.

To the contrary, the Court reasoned:

‘[T]he implied covenant of good faith is the obligation to preserve the spirit of the bargain rather than the letter, the adherence to substance rather than form[; i]t requires more than just literal compliance with the policy provisions and statute’ . . . Taken together, [Brightstar’s arguments] do not adequately respond to Miller’s argument that ‘the spirit of the bargain’ was that he would benefit from the deal through the value of his put and call rights.”

The Power of the Implied Covenant of Good Faith and Fair Dealing.

Miller’s claims highlight the power of the implied covenant claim in business divorce litigation over the obligation and scope of owners’ agreements. Here, Miller successfully combined his options rights with the implied covenant to assert direct claims for Brightstar’s willful impairment of Harvestar’s value—which ordinarily is the quintessential derivative claim. And if that weren’t enough, Miller’s implied covenant claim survived in spite of his almost impossibly broad waiver of Brightstar’s fiduciary duties regarding its operation of Harvestar. A powerful remedy indeed.

Other owners would be wise to note Miller’s strategy, and to consider how the implied covenant of good faith and fair dealing affects the all-too-important direct/derivative distinction, especially where the owners’ agreement contains cross-purchase rights.

A final note: In my view, this case is worth watching based on how the Court treats Miller’s available damages going forward: if proceeding with his direct claims, my guess is that Miller is only entitled to recover damages for the diminution of his “call shares,” rather than for the 24.5% shares that he already owns. Neither the District Court nor the Second Circuit gave much guidance on that issue, but I can envision good arguments either way; perhaps we’ll see them at the summary judgment stage.

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