VC Experts - July 30, 2014
A recent case in the California Court of Appeals underscores the dangers that await venture capital firms brave (or foolish) enough to fund companies in the midst of internal disputes. In American Master Lease LLC v Idanta Partners, Ltd., the Court of Appeals for the Second District made clear that a venture firm can be liable for aiding and abetting a breach of fiduciary duty even though the firm itself owes no fiduciary duties to the injured parties. That was an interesting legal ruling, because venture firms don't ordinarily think of themselves as owing fiduciary duties in arms-length contractual relationships. It was also interesting from a legal point of view because one of the other main forms of "secondary" liability for breaches of fiduciary duty – conspiracy – had typically required that the defendant owe an independent fiduciary duty to the plaintiff. The American Master Lease court ruled that even in the absence of a fiduciary duty, a defendant venture firm can be liable for aiding and abetting if it "makes a conscious decision to participate in tortious activity for the purpose of assisting another in performing a wrongful act."
So what did the defendants do that the jury and appeals court found crossed the line? The opinion is long and complicated, but I'll try to simplify it. The concept behind the American Master Lease ("AML") business was a twist on familiar Section 1031 real estate exchanges, allowing real estate investors who want to retire or otherwise get out of active management of their properties to exchange their individual real estate interests for a fractional interest in a larger entity. The founder and his family members owned 75% of the AML business; three gentlemen (Andrews, Runnels and Franklin, who had been involved in the founder's previous business), owned the remaining 25%.
The source of the problems to come was an extremely broad non-compete contained in the LLC agreement, which essentially disallowed all competition with AML unless the majority gave consent. Things came to a head in a dispute over choosing a new investment partner (needed for funding the real estate purchases of the larger entity). The founder was "concerned about protecting AML's business method" and was opposed to pursuing any investment partner at all, preferring to focus on a licensing strategy; the three minority members of the LLC (who formed a so-called "Operating Group" under a separate management agreement) wanted a new investment partner and suggested Idanta (a venture capital firm bankrolled by the Bass family, described by the Court with considerable understatement as a "wealthy Texas family engaged in the oil business").
The two factions within AML discussed various structures for achieving their objectives, but could not reach agreement. The founder wanted a joint venture with some other company, with Runnels and Franklin serving as employees; they said that was unacceptable, because that they had never been employees and, moreover, that they had been advised by their own counsel that the purported non-compete in the AML LLC agreement was unenforceable under California law.
Runnels and Franklin then took bold action. Runnels incorporated a new entity ("FPI") owned by himself and Franklin; FPI then sold an 85% interest in FPI to Idanta, its founder David Dunn and Dunn's family trust for $2.3 million; then the Operating Group granted FPI a non-exclusive license to use the AML business method and received a $50,000 advance on royalties. Voila! Everyone's objectives seemingly met. But the AML founder was not entirely pleased when he learned that Runnels was FPI's sole incorporator, and reminded him in an email of his non-compete obligations; but at the same time, he also wrote that he was "hopeful" that Runnels and Franklin were "moving forward to protect the Company's intellectual property and generate revenue." The AML founder further expressed his mixed feelings in a conversation with Franklin when Franklin delivered FPI's $50,000 royalty check, stating memorably "I don't know whether this is the best thing that ever happened to us or whether I've been f'd." (Franklin said it was the former, in case you were wondering).
The founder thereafter decided it was the latter (that he'd been "f'd"), and had his lawyer send a letter to the Idanta parties, saying that the license was unauthorized, the non-compete was in full force and effect, and that any monies received by FPI would be recoverable under a variety of theories. The venture firm's lawyers fired back a letter saying that the whole matter was really a dispute between the AML members, and, in another memorable turn of phrase, noted that Idanta "believes it is appropriate for those parties to resolve those matters themselves without the involvement of Idanta Partners."
That sentiment was not shared. The AML founder initiated an arbitration against Runnels, Franklin and Andrews, which eventually settled. AML then sued Idanta, its founder David Dunn, his family trust, and his son Steven under numerous causes of action. After five years of litigation, the jury returned a verdict finding the defendants liable for over $7 million in restitution.
What lessons can venture capital firms learn from this lengthy story? (which, by the way, will become lengthier still, as it has been sent back to the trial court for a retrial on various damages issues.)
First, be wary of situations in which the founder and other members of the organization are at loggerheads over fundamental issues, and the venture firm is providing a "solution" that favors one side over the other.
Second, advice of counsel is not a panacea. Here Runnels and Franklin apparently had received legal advice that the non-compete was unenforceable under California law, which appeared to be a strong argument. But in the end, the fiduciary duties imposed on members of California LLCs under then -existing California law carried the day for the plaintiffs.
Third, apply the "front page of the newspaper" test to creative solutions. Having members of the Operating Group on both sides of the non-exclusive licensing transaction between AML and FPI, in close proximity to the sale of FPI stock to Idanta, probably looked bad to the jury, no matter how justifiable it may have been under the law.
Finally, put this decision in perspective. Many Delaware LLC agreements disavow any fiduciary duties between and among the LLC members, and many fact situations will be more benign from the venture capital firm's perspective. Nonetheless, it is important to recognize that wading into conflict situations can turn into aiding and abetting breaches of fiduciary duty or other torts, with potentially serious financial consequences.
Republished with permission from VC Experts