Robert Zimmerman v. Katherine D. Crothall, et al., C.A. No. 6001-VCP (Del. Ch. March 27, 2012) (Parsons, V.C.)
In this opinion, the Court of Chancery granted summary judgment in favor of defendants on claims of breach of the duty of care as well as the aiding and abetting thereof, and certain claims for breach of the Limited Liability Company Agreement (the “Operating Agreement”) of Adhezion Biomedical LLC, a Delaware limited liability company (“Adhezion”). The Court denied summary judgment on claims of breach of the duty of loyalty, aiding and abetting such breach, and on other breach of contract claims arising under the Operating Agreement. All claims related to three separate issuances by Adhezion of preferred limited liability company interests (“Preferred Units”) between 2009 and 2011 for the purpose of raising capital from investors (together, the “Preferred Unit Transactions”). Robert Zimmerman, a co-founder and former CEO of Adhezion who owned common limited liability company interests (“Common Units”) in Adhezion brought the claims against Adhezion, certain directors and members of Adhezion, and affiliates of such members.
In each of the Preferred Unit Transactions, existing members of Adhezion, which were venture capital investors (the "VC Members”), purchased either Preferred Units or notes convertible into Preferred Units. The directors that approved the issuance of such Preferred Units included those appointed by the VC Members, and those same directors were principals in the VC Members or their affiliates.
The Delaware Limited Liability Company Act (“LLC Act”) gives parties to a limited liability company agreement like Adhezion’s Operating Agreement the ability to modify the default fiduciary duties and the liability for the breach thereof. The Court, however, found that the Adhezion Operating Agreement did not contractually modify default fiduciary duties of members, and with respect to directors provided that they “are required to carry out their duties and exercise their powers . . . in good faith and in a manner reasonably believed by the Directors to be in the best interests of the Company and its Members and with such care, including reasonable inquiry, skill and diligence, as a person of ordinary prudence would use under similar circumstances.” As such, the Court applied to Adhezion, and its defendant directors and members, the default fiduciary duties of directors and shareholders of Delaware corporations. One of the more notable aspects of this case is the Court’s application of corporate law and principles to a limited liability company.
Plaintiff’s duty of care claims were made against the defendant directors for allegedly approving the Preferred Unit Transactions recklessly and with gross negligence. The Court found that provisions of the Operating Agreement exculpating directors for failing to perform duties in a manner that was not reckless did not shield them from liability for breach of the duty of care. As the Court explained, in Delaware corporate and partnership law (and by implication, LLC law), the standard for breach of the duty of care is recklessness or gross negligence. Consequently, the exception in the Operating Agreement’s exculpatory provision, which permits liability against directors for recklessness acts, allows for liability for breaches of the duty of care. However, with respect to the duty of care claim the Court ultimately found that the plaintiff failed to present evidence sufficient to infer that the directors acted recklessly or with gross negligence, and failed to present evidence sufficient to overcome the protective presumption provided to the directors by the business judgment rule. On that basis, the Court held that the director defendants were entitled to summary judgment on the breach of duty of care allegations, and the claims of aiding and abetting thereof by other defendants.
Plaintiff’s duty of loyalty argument was that a majority of Adhezion’s directors, as well as the VC Members that allegedly controlled the company, sat on both sides of the Preferred Unit Transactions and benefited at the expense of members owning Common Units. Plaintiff claimed that in doing so (i) director defendants acted in bad faith, and (ii) all defendants engaged in self-dealing. To succeed on a bad faith claim a plaintiff must overcome a presumption of good faith by showing that the actions on which the claim is based were taken by defendants with an intention to disregard their duties. The Court granted summary judgment to the defendant directors on the bad faith claim based on its earlier analysis, in which it found that the directors’ actions in approving the Preferred Unit Transactions were not grossly negligent or reckless, and therefore found that such actions could not be intentional or in bad faith.
In evaluating the self-dealing component of the duty of loyalty claim, the Court determined that the entire fairness standard of review should apply to the actions of the defendants. That stringent standard of review applies when a majority of interested directors approves a transaction or a controlling stock or interest holder sits on both sides of a transaction, controls the terms of the transaction, and receives a benefit not provided to all stock or interest holders. The plaintiff claimed that a majority of the directors of Adhezion had interests in the VC Members, and that the VC Members, collectively, constituted a controlling shareholder group that dictated the terms of the Preferred Unit Transactions. The Court found that a genuine issue of material fact existed such that it could be found that (i) a majority of the board was either interested or not independent when they approved the Preferred Unit Transactions, (ii) the VC Members collectively controlled Adhezion for purposes of approving the Preferred Unit Transactions, and (iii) members owning Preferred Units were the exclusive beneficiaries of certain advantages under the Preferred Unit Transactions that were not made available to all members.
One of defendants’ counter arguments against application of entire fairness review was that provisions of the Operating Agreement substantially similar to Section 144 of the Delaware General Corporation Law (the “DGCL”) provided a safe harbor from such review, and could provide defendants with the benefit of the presumption afforded by the business judgment rule. The Court, however, found that the purpose of such provisions of the Operating Agreement and Section 144 of the DGCL is not to provide a safe harbor from liability for breach of the fiduciary duty of loyalty, but rather to address merely whether an interested transaction is void or voidable solely because interested directors voted on the transaction. Having found that defendants did not sufficiently demonstrate that the Preferred Unit Transactions were not self-interested or that the Operating Agreement provided any protection for such transactions, the Court ultimately denied summary judgment on the duty of loyalty claims and the claims of aiding and abetting thereof. Similarly, with respect to plaintiff’s claim that the defendants failed to comply even with the applicable provisions of the Operating Agreement such that the Preferred Unit Transactions were void or voidable, the Court concluded that it could not determine whether all of the requirements of such Operating Agreement provisions had been met without trial, and therefore also declined to resolve such issue on summary judgment
The last question examined by the Court was whether amendment of the Operating Agreement to create and issue certain Preferred Units was done in a manner violative of its express provisions. The Court decided not to grant summary judgment to defendant on plaintiff’s claim for breach of contract based on the allegedly unauthorized amendment because it found the Operating Agreement’s provisions ambiguous on the issue of whether such amendment could be effectuated without the approval of owners of certain Common Units.