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Minority Members Allegedly Exploited Contract Rights in Breach of Fiduciary Duties to Acquire Company Assets on the Cheap

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May 6, 2020
Delaware Business Court Insider

Albert ManwaringDelaware law requires directors of a corporation to strive in good faith and on an informed basis to maximize the value of the corporation for the benefit of all of its stockholders, and not to prefer the interests of stockholders with contract rights or preferences. Consequently, where the interests of stockholders diverge from the contracts rights of other stockholders, directors and controlling stockholders may breach their fiduciary duty of loyalty by exploiting or opportunistically favoring their contract rights over the interests of the stockholders as a whole.

This potential conflict of interest is exacerbated by directors appointed by and beholden to constituent stockholders, which often creates a dual-fiduciary problem, for which Delaware law does not provide a safe harbor. In short, directors beholden to constituent stockholders may subordinate their judgment for the corporation and all of its stockholders in favor of the contract interests of the constituent stockholders. Constituency directors, who act to benefit constituent stockholders at the expense of the interests of the corporation and its stockholders as a whole, are subject to a claim for breach of their fiduciary duty of loyalty, including the duty of good faith, which is a component of the duty of loyalty under Delaware law.

These principles apply by default to a limited liability company’s managers and its controlling members where an operating agreement is silent, or does not unambiguously disclaim traditional fiduciary duties. This was the case in a recent Court of Chancery decision, Skye Mineral Investors, LLC v. DXS Capital (U.S.) Ltd., C.A. No. 2018-0059-JRS (Del. Ch. Feb. 24, 2020) (Slights, V.C.).

By way of background, Skye Mineral Partners, LLC’s (“the LLC”) operating subsidiary owned valuable mineral deposits. Under the operating agreement, the approval of the minority members was necessary for the LLC to obtain financing. After the minority members’ designated manager to the board learned that the mineral deposits of the subsidiary were worth $600 million, the minority members and their designated manager, who was beholden financially to the minority members, devised a plan to acquire the LLC subsidiary’s debt, and then exercise the minority member’ contract right to block refinancing that was necessary to continue the subsidiary’s operations and service the debt. Their plan was to force the subsidiary into bankruptcy, where its assets were purchased by affiliates of the minority members for $40 million.

In Skye Mineral Investors, LLC, the Court held that plaintiffs, the majority members of an LLC, pled claims for breach of the fiduciary duty of loyalty that minority members exploited their contract right to block and control financing decisions in bad faith to enable them to acquire the LLC’s assets on the cheap at the expense of the interests of the LLC and its members. The Court found that neither a provision in the operating agreement that waived fiduciary obligations for corporate opportunities, nor a provision that allowed members to vote in the member’s sole discretion, were sufficient to disclaim traditional fiduciary duties applicable to a general corporation. The Court reasoned that express disclaimer language in the operating agreement was necessary to exempt the default traditional fiduciary duties.

Applying traditional fiduciary duties, the Court ruled that the plaintiffs had pled legally-sufficient claims that the minority members improperly exercised their control to prevent the majority members from financing the LLC subsidiary’s debt and operations to force the subsidiary into bankruptcy, where affiliates of the minority members were able to purchase its assets on the cheap. To have the duties of a controller, the Court found that minority members exercised actual control via contractual blocking rights to “channel the corporation into a particular outcome,” that enabled them to prevent financing that effectively shut down the LLC.

The Court also held that plaintiffs had pled sufficient claims that the minority members’ designated manager breached his fiduciary duty of loyalty. The Court explained that “[w]hen a fiduciary . . . intentionally ‘sit[s] back’ while his company ‘collapses’ so that another to whom he is beholden can buy the company’s assets ‘out of bankruptcy very cheap,’” the constituency manager’s divided loyalties may result in a breach of his duty of loyalty to the LLC and its members.

Delaware Business Court Insider l May 6, 2020 

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