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Delaware Court of Chancery Applies Direct/Derivative Distinction In Voting Context

Clifford Paper, Inc. v. WPP Investors, LLC, 2021 WL 2211694 (Del. Ch. Jun. 1, 2021)
The disenfranchisement of an investor with voting or consent rights often is considered to be a direct harm, thus permitting the investor to bring direct claims. Sometimes, however, the alleged harm from the violation of voting rights is to the company, and it does not directly affect the investor. The Court of Chancery’s recent decision in Clifford Paper, Inc. v. WPP Investors, LLC, 2021 WL 2211694 (Del. Ch. Jun. 1, 2021), illustrates that, in such instances, a court applying Delaware law may treat those claims as derivative.

Plaintiff Clifford Paper, Inc. ("CPI") formed World Pac Paper, LLC ("WPP" or "Company") with the defendants. CPI and the defendants shared management duties, and CPI separately performed services for the Company. CPI withdrew from the Company in 2018 after asserting that the defendants had breached the Company's operating agreement in numerous ways, including by taking unilateral action on matters where CPI had voting or veto rights, and that the defendants had breached their fiduciary duties.

CPI subsequently sued in 2020 alleging various breaches of the Company's operating agreement, including that it had been disenfranchised. The defendants moved to dismiss on the theory that CPI lacked standing because its claims were derivative and that, under Delaware's LLC Act, former members do not have standing to bring derivative claims. See 6 Del. C. § 18-1001. 

In considering the defendants' motion to dismiss, the Court first addressed CPI's argument that Delaware’s so-called Tooley framework to differentiate between direct and derivative claims did not apply in the context of a two-member LLC. The Tooley test asks whether (i) the company or the individual suffered the harm, and (ii) the company or the individual would receive the benefit of any remedy. See Tooley v. Donaldson, Lufkin & Jenrette, Inc., 845 A. 2d 1031, 1039 (Del. 2004). 

Here, the Court rejected CPI's proposed distinction and concluded that the claims were derivative. The Court noted that the LLC Act does not recognize an exception for two-member companies when discussing the requirements for derivative actions. And the precedents CPI relied upon were inapt, as they involved dissolved companies, or other circumstances where a plaintiff with standing properly brought derivative claims, but the court reasoned a remedy might flow directly to investors. See, e.g., In re Cencom Cable Income Partners, L.P., 2000 WL 130629 (Del. Ch. Jan. 27, 2000) (addressing direct/derivative distinction in the context of a dissolved limited partnership); In re El Paso Pipeline P’rs, LP Deriv. Litig., 132 A.3d 67, 121 (Del. Ch. 2015) (discussing equitable grounds to allow stockholders to recover on derivative claims directly), rev’d on other grounds sub nom. El Paso Pipeline GP Co., L.L.C. v. Brinckerhoff, 152 A.3d 1248 (Del. 2016). Such precedents did not support, however, disregarding the derivative nature of the claims in this different context. 

The Court then explained, claim by claim, that the benefit of any remedy here would flow first to the company. Specifically, CPI argued it would not have approved of (i) creating a new lucrative executive position for a relative of one of the defendants, and (ii) hiring a new financial advisor. The Court reasoned, however, that CPI alleged such actions resulted in financial harm to the Company, for which CPI sought compensatory damages. Accordingly, the claims were derivative. Because CPI withdrew from the Company before filing the action, CPI lacked standing to pursue such claims. Accordingly, the Court granted the defendants’ motion to dismiss. 



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