Zimmerman v. Crothall, C.A. No. 6001-VCP (Del. Ch. Jan. 31, 2013) (Parsons, V.C.)
In this memorandum opinion, the Delaware Court of Chancery found that the defendants breached a limited liability company agreement but awarded only nominal damages because the plaintiff suffered no harm. The Court also rejected claims that the defendants breached their fiduciary duties.
The plaintiff, Robert Zimmerman (“Zimmerman”), was a member of Adhezion Biomedical LLC, a Delaware limited liability company (the “Company”) that was managed by a Board of Directors (the “Board” or the “Director Defendants”). Zimmerman brought his lawsuit after the Board caused the Company to issue preferred units, promissory notes, and warrants to certain Company Directors and investors to raise much needed cash (the “Challenged Transactions”). Zimmerman alleged that the Director Defendants breached the limited liability company agreement of the Company (the “Agreement”) by failing to obtain the consent of the Company’s Common Members before consummating the Challenged Transactions. Specifically, Zimmerman argued that the Agreement required the Board to obtain the consent of the Common Members to authorize additional Series A Preferred units and to amend the Agreement to reflect the creation, authorization, and issuance of Series B Preferred units.
Zimmerman also alleged that the Director Defendants breached their fiduciary duty of loyalty because the Challenged Transactions were self-dealing transactions that were not entirely fair to the Company. Zimmerman further alleged that two investors in the Company (one, “Liberty,” and the other, “Originate,” and collectively with the Director Defendants, the “Defendants”), owed fiduciary duties to the Company and its minority Members by virtue of being part of a group that controlled the Company, and breached those duties by causing the Company to consummate the Challenged Transactions. Lastly, Zimmerman alleged that Originate, Liberty, and Thomas Morse, a principal at Liberty, were liable for aiding and abetting the Director Defendants’ breach of their fiduciary duty.
The Court first held that the Director Defendants breached the Agreement. Although there is no statutory requirement that there be an amendment to a limited liability company agreement to increase the number of authorized limited liability company interests of a limited liability company, the Court held that the Agreement required such an amendment. According to the Court, an amendment to the Agreement approved by the Common Members was required to increase the number of authorized Series A Preferred units. Because the Director Defendants acted unilaterally without the consent of the Common Members, the Director Defendants breached the Agreement. In addition, the Court held that the Director Defendants’ issuance of Series B Preferred units was unauthorized under the Agreement due to their failure to obtain the consent of the Common Members.
The Court then rejected the claims that the Defendants breached their fiduciary duties. First, the Court held that there was no basis for Zimmerman’s claims against Liberty and Originate because they did not exercise control over the Company and, therefore, owed no fiduciary duties.
Second, the Court found that the Director Defendants did not breach their fiduciary duties. Section 6.13 of the Agreement (“Section 6.13”) expressly permitted the Director Defendants to contract, or otherwise deal, with the Company provided that payments and fees were comparable to those paid to unrelated third parties (the “Arm’s-Length Restriction”). In addition, Section 6.13 provided that no transaction between the Director Defendants and the Company would be void or voidable solely for that reason, if: (a) the disinterested Directors approved the transaction in good faith after knowing all the material facts of the transaction (the “Disclosure Safe Harbor”); or (b) the transaction was fair to the Company (the “Fairness Safe Harbor”).
The Court held that the Arm’s-Length Restriction and the Fairness Safe Harbor required the Court to review the Challenged Transactions under the entire fairness standard of review. The first step in the Court’s analysis was to determine which party had the burden of proof. The Court noted that in the corporate context and in the case of a default fiduciary duty in the limited liability company context, the initial presumption would be that a director defendant would have the burden of proving entire fairness. Here, however, because the fiduciary duties were expressly written in the Agreement and conferred on the Director Defendants the right to deal with the Company, the Court held that Zimmerman had the initial burden of proving that the Challenged Transactions were not entirely fair to the Company. The Court found that Zimmerman could not meet his burden of proof, in part, because (i) the Company needed cash, (ii) the Director Defendants investigated multiple sources of funding before consummating the Challenged Transactions, and (iii) funding options were limited because the Company was a risky investment.
The Court acknowledged, however, that its conclusion that Zimmerman had the initial burden of proof was not free from doubt. Nevertheless, the Court found that even if the Director Defendants had the initial burden of proof, they satisfied the Disclosure Safe Harbor, which gave them the benefit of the business judgment rule, or at a minimum, shifted the burden of proof to Zimmerman. Because Zimmerman failed to prove that the Challenged Transactions were unfair, he could not meet his burden of proof if the Director Defendants were entitled to the presumption of the business judgment rule. Thus, the Court rejected the breach of fiduciary duty claims regardless of which party had the initial burden of proof. As a result, the Court also rejected the claims against Originate, Liberty, and Thomas Morse for aiding and abetting breaches of fiduciary duties. Further, because the Challenged Transactions were fair to the Company, the Court found that Zimmerman suffered no harm as a result of the Director Defendants’ breaches of the Agreement and awarded only nominal damages of $1.
Finally, the Court rejected Zimmerman’s request that the Defendants reimburse the Company for legal fees it advanced to the Defendants’ counsel for this action. According to the Court, the Delaware Limited Liability Company Act, 6 Del. C. §§ 18-101 et seq., defers completely to contracting parties “to create and delimit rights and obligations with respect to indemnification and advancement of expenses.” The Agreement required indemnification of the Director Defendants unless the Court found that their acts were not taken in good faith or resulted from gross negligence, willful misconduct, or fraud. Because Zimmerman failed to prove any of these, indemnification was required. Further, given the stage of the litigation, whether or not advancement of expenses was permitted under the Agreement was a moot issue. As such, the Court denied Zimmerman’s request for reimbursement.