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How to Open the Door to Chancery

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July 19, 2017
Delaware Business Court Insider

Sometimes more is not a good idea. That is the case when a complaint alleges multiple bases to invoke the jurisdiction of the Delaware Court of Chancery, but still fails to sustain that subject matter jurisdiction. The recent decision in Yu v. GSM Nation, Del. Ch. C.A. No. 12293-VCMR (July 7), shows why that can be a costly failure. For the plaintiff in the GSM case spent over a year trying to sustain the Court of Chancery's jurisdiction only to fail to do so. Had the plaintiff instead filed in the Delaware Superior Court's CCLD docket, he very well might have had a trial by the time his Court of Chancery complaint was dismissed.

The facts alleged in the GSM complaint were fairly straight forward. Warren David Yu lent GSM $3,500,000 to develop its new business. When GSM failed to repay him under the terms of the loan documents, Yu sued GSM, its founding member Ahmed Khattak and several entities related to Khattak. The Yu complaint alleged six counts, using the "magic words" he thought would invoke the Court of Chancery's jurisdiction. He failed, however, to allege facts that supported that jurisdiction.

To begin with, Chancery jurisdiction must be based on either: a statutory grant of subject matter jurisdiction (such as a books and records claim under the Delaware General Corporation Law); an equitable right (such as a fiduciary relationship); or an equitable remedy (such as an injunction). But the equitable right or remedy must be supported by specific factual allegations that would show that right exists or that remedy cannot be adequately supplied by an action at law. For example, Yu generally alleged that he had the equitable right to pierce the corporate veil to see Khattak. Yet Yu failed to also allege facts that would warrant veil piercing, such as a failure to observe corporate formalities that amounted to treating Khattak's corporations as mere sham entities. Hence, Yu failed to show there was Court of Chancery jurisdiction over that claim. Similarly, Yu alleged a claim for equitable fraud. Such a claim must be based on a fiduciary relationship, but Yu failed to show he had such a relationship with GSM or Khattak.

The complaint's claims for an equitable remedy fared no better. Claims for a constructive trust, rescission, reformation and an accounting seek an equitable remedy. However, that alone is not sufficient. Rather, to invoke Court of Chancery jurisdiction the equitable remedy must be necessary because an action at law would be inadequate for some reason. Yu was really just seeking money damages and he failed to plead facts that showed a damages award was inadequate, such as a fraudulent transfer of assets to avoid satisfaction of a judgment.

The decision in United BioSource v. Bracket Holding, Del. Ch. C.A. No. 12886-CB (May 23), explains how to meet this burden of showing damages alone is not an adequate remedy. Bracket Holding involved a tax refund allegedly due to the plaintiff under the terms of an asset sale to the defendant. That would seem to be a classic case where a damage award would be an adequate remedy. However, the Court of Chancery sustained its subject matter jurisdiction. Why it did is instructive.

To begin with, the asset sale contract had provisions that stipulated "irreparable damage would occur" in the absence of a court granting an injunction on specific performance of an injured party's contractual rights. The court noted that such agreements do not alone confer jurisdiction over the dispute upon the Court of Chancery. Nonetheless, such a provision helps and in an appropriate circumstance may be sufficient to demonstrate the need to avoid irreparable harm by an equitable remedy, see, e.g., Gildor v. Optical Sols, (Del. Ch. June 5, 2006).

What did tip the balance in favor of equitable jurisdiction in Bracket Holding? Just as in prior decisions, the money in dispute was held by a third party escrow agent—a separate legal entity. A money judgment against Bracket Holding alone did not require the nonparty escrow agent to pay the plaintiff. That direction to pay had to come from Bracket Holding itself, something the court could force it to do by an order of specific performance. That Bracket Holding was to be sold and thus might not pay a money judgment also helped sustain equitable jurisdiction. This last point about possible inability to pay was not accepted by the GSM decision as enough to sustain jurisdiction, however.

These two decisions show the critical importance of the factual allegations of a complaint that seeks entry into the Court of Chancery. Mere labeling a parties' relationship as based on fiduciary duties or adding an equitable remedy as a prayer for relief is not sufficient to confer jurisdiction. As the GSM decision shows, much time and money can be lost by failing to understand this law.

Delaware Business Court Insider | July19, 2017

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