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Chancery Rejects Challenge to Financing Made Open to All Investors, Reasons the LLC Operating Agreement Allows Self-Interested Conduct, so any Claims Must Assert Bad Faith

MKE Holdings Ltd. v. Schwartz, C.A. No. 2018-0729-SG (Del. Ch. Jan. 29, 2020).

Verdesian Life Sciences, LLC is an agricultural company focused upon rolling up various companies with proprietary plant health technologies. All members of the Board of Managers of Verdesian were appointed by Paine Schwartz Partners, LLC (“Paine”), a private equity firm that owned over seventy percent of the Class A Units of the company. Paine also benefited from a management agreement that entitled it to receive certain management fees tied to acquisitions. The LLC Operating Agreement required the Managers to perform their duties in good faith and in a manner they reasonably believed to be in or not opposed to the best interests of Verdesian. However, the Operating Agreement also allowed Managers and Members to “consider only such interests and factors as such Manager or Member desires, including its, his or her own interests” when facing discretionary decisions. The Court of Chancery concluded that the Operating Agreement “directs the Managers to operate in good faith and with ordinary care and effectively exculpates Managers for conflicted, negligent and other detrimental decisions … so long as taken in good faith.”

Plaintiffs were minority interest holders who believed that the Managers actively concealed important information about Verdesian’s last, and by far largest, roll-up acquisition, which was going to be completed in part through raising equity from current investors. Specifically, an outside auditor and a customer of Verdesian had warned the Managers that the reported earnings of the acquisition target were not sustainable, but these warnings were not passed on to the minority interest holders who were then in the process of purchasing additional interests. The Court accordingly allowed a fraud claim to proceed.

The Court rejected, however, Plaintiffs’ argument that a later financing involving the issuance of a new class of preferred equity interests violated the LLC Operating Agreement and should be subject to entire fairness review. Citing WatchMark v. ARGO Global Capital LLC, 2004 WL 2694884 (Del. Ch. Nov. 4, 2004), the Court stressed that all investors in Verdesian had an equal opportunity to participate in the funding round. The Court found unpersuasive the plaintiffs’ argument that the round was intentionally set at too high a price to discourage participation from the minority investors; the Court noted that the fact the management-insiders participated at the same price belied the allegation, which also was plead only in a conclusory manner. Notwithstanding the possibility that the controlling shareholder and the Managers it controlled might have acted in their own self-interest, the Operating Agreement explicitly contemplated and allowed self-interested decisions. For there to be a breach, the Managers must act in bad faith. The Court found that Plaintiffs had failed to adequately allege that the equity offering was made in bad faith and dismissed the claim for breach of the Operating Agreement.