Delaware Court of Chancery Holds Number of Members in LLC Does Not Determine Whether Claims Are Direct or Derivative

In Clifford Paper, Inc. v. WPP Investors, LLC, et al., C.A. No. 2020-0448-JRS (Del. Ch. June 1, 2021), the Delaware Court of Chancery held that plaintiff Clifford Paper, Inc.’s (“CPI”) asserted derivative (as opposed to direct) claims against defendants WPP Investors (“Investors”) and Edgar L. Smith, thus necessitating the dismissal of those claims because CPI no longer was a member of World Pac Paper, LLC (“WPP”) when CPI filed suit.

Facts

In 2004, CPI, along with defendants Investors and its owners, Mr. Smith and Richard A. Baptiste (collectively, “Defendants”), formed WPP to distribute paper and packaging products and provide printing, shipping and warehousing consignment services to commercial and retail clients. CPI and Investors owned 45% and 55% of WPP, respectively. Under the company’s Operating Agreement, Smith and Baptiste, along with CPI’s president, John P. Clifford, were designated to oversee WPP’s operations as its managers.

On June 11, 2004, WPP entered into an Administrate Services & Raw Material Supply Agreement with CPI (the “Services Agreement”). Under this agreement, CPI managed WPP’s administrative tasks including accounts receivable, invoicing, financing, and materials sourcing and coordination. The Services Agreement contained a New Jersey choice of law and forum selection clause.

In September 2016, Smith expressed his desire to promote his wife, Dr. Toni M. Robinson-Smith, who had been serving in an administrative and sales role, to a newly-created Vice President–Administration position, with an annual salary to match the position. CPI objected because it viewed the salary associated with Dr. Robinson-Smith’s promotion to be beyond the means of the company, and her responsibilities would be duplicative of CPI’s under the Services Agreement. Nevertheless, Smith and Baptiste created the role and promoted Dr. Robinson-Smith to fill it.

On March 10, 2017, Defendants sent CPI a letter giving 90 days’ notice of WPP’s intent to terminate the Services Agreement (the “Termination Letter”). CPI then initiated a lawsuit against WPP, Investors, Smith and Baptiste on May 1, 2017, in New Jersey state court asserting various claims arising from WPP’s alleged breach of the Operating Agreement and the Services Agreement (the “New Jersey Action”). The claims relating to the Operating Agreement were dismissed without prejudice in accordance with that agreement’s exclusive Delaware forum selection clause.

On February 21, 2018, CPI and Investors entered into a Consent and Acknowledgement to Withdrawal Agreement (the “Withdrawal Agreement”), formalizing CPI’s withdrawal as a member of WPP. More than two years later, on July 9, 2020, CPI filed suit against Defendants alleging breaches of the Operating Agreement and breaches of fiduciary duty. CPI amended its complaint on September 21, 2020, and on October 23, 2020, Defendants moved to dismiss CPI’s claims.

CPI Lacked Standing for Its Derivative Claims

Defendants’ primary argument was that CPI lacked standing to pursue its derivative claims because it no longer was a member of WPP when it filed suit. Indeed, under 6 Del. C. § 18-1002, “[i]n a derivative action, the plaintiff must be a member or an assignee of a limited liability company interest at the time of bringing the action.” “Thus, to the extent CPI’s claims are derivative, they fail as a matter of law.” Given that reality, CPI argued that its claims were direct, not derivative, because the amended complaint asserted that CPI was harmed directly.

Typically, the Court of Chancery distinguishes between direct and derivative claims by applying a standard set forth in Tooley v. Donaldson, Lufkin & Jenrette, Inc., 845 A.2d 1031 (Del. 2004). Under that analysis, determining whether a claim was direct or derivative depended on: “(1) who suffered the alleged harm (the [LLC] or the suing [member], individually); and (2) who would receive the benefit of any recovery or other remedy (the [LLC] or the [members], individually)?” CPI, however, insisted that the Court of Chancery should not apply that standard because WPP was a two-member LLC; therefore, any harm to the LLC caused by one member, Investors, flows directly to the other member, CPI.

The vice chancellor rejected that argument, pointing out that “6 Del. C. § 18-1001 does not distinguish two-member LLCs from other LLCs when addressing derivative actions — a distinction our General Assembly easily could have codified had it been so inclined.” In fact, then–Vice Chancellor Montgomery-Reeves applied Tooley’s test to fiduciary duty claims asserted by one 50% member of an LLC against the other 50% member; ultimately dismissing the plaintiff’s claims after concluding that they were derivative. Vice Chancellor Slights concluded that the same analysis was appropriate with respect to CPI’s claims.

Under the first prong of Tooley, the “claimed direct injury must be independent of any alleged injury to the corporation.” The second prong of Tooley provides that “[w]here all of a corporation’s stockholders are harmed and would recover pro rata in proportion with their ownership of the corporation’s stock … then the claim is derivative in nature.” Casting aside the amended complaint’s artful language, the court found that CPI’s claims were derivative.

With respect to CPI’s contract claims, this decision notes that allegations that Defendants diverted funds are “quintessentially derivative … [b]ecause it is [WPP’s] funds Defendants are alleged to have diverted[; thus,] the harm caused by Defendants flows directly to [WPP], and only derivatively to its members,” including CPI. Any recovery would flow first to WPP, then to CPI on a pro rata basis. In addressing CPI’s allegations that Defendants breached the Operating Agreement by denying CPI the right to vote on certain company actions, the court similarly concluded those claims were derivative because the underlying harm was that Defendants’ conduct led to waste of WPP’s resources. Thus, the harm and remedy belonged to WPP first, and then to CPI as a member of WPP.

Much like CPI’s contract claims, CPI’s breach of fiduciary claims were found to be derivative. In support of its fiduciary duty claims, CPI alleged that Defendants breached their duty of loyalty by (1) postponing WPP’s expansion of a lucrative business opportunity until after the termination of the Services Agreement; (2) diverting sales from WPP customers to Investors, thus denying CPI’s right to share in WPP’s profits; and (3) unilaterally appointing Investors as WPP’s administrative services agent without allowing Clifford a vote. CPI contended that those claims were direct because Defendants prevented CPI from exercising its voting rights through material misrepresentations. The Court of Chancery disagreed, holding that the harm associated with Defendants’ alleged postponement of a business expansion and purported diversion of revenue belongs to WPP, and the recovery of any lost profits would go to WPP first before being shared with members. The same is true of the assertion that Investors diverted funds to itself because the related profits would first be recovered by WPP before being shared derivatively by the company’s members. Such claims, the court held, are the “very definition of a derivative claim under Tooley.”

After concluding that CPI’s claims were derivative, the Court of Chancery held that CPI lacked standing to bring them, under 6 Del. C. § 18-1002, because CPI ceased to be a member of WPP in 2018 after signing the Termination Agreement.

Takeaway

Neither the number of members in an LLC, nor a plaintiff’s artful pleading is controlling in terms of determining whether claims are direct or derivative. Even where there are just two members of an LLC, the Court of Chancery will apply the Tooley analysis to conclude that claims are derivative if the harm and remedy belong to the LLC first before flowing to the members by virtue of their position in the company.