Court of Chancery Explains Demand Futility Pleading Requirements in the Context of Delaware LLCs
By: Scott Waxman and Zack Sager
In LVI Group Investments, LLC v. NCM Group Holdings, LLC, the Court of Chancery of the State of Delaware looked to Delaware corporate law for demand futility pleading requirements in dismissing a derivative claim for breach of fiduciary duties against managers of a Delaware limited liability company (an “LLC”). In addition, the Court of Chancery analyzed the requirements for a member of an LLC sufficiently to plead a direct claim against managers of the LLC and analyzed the requirements for pleading a claim of fraud.
LVI Group Investments involved two Delaware LLCs that merged their businesses into a single Delaware LLC (the “Merger”) called NorthStar Group Holdings, LLC (“NorthStar”). As a result of the Merger, the two merging LLCs became the members of NorthStar. One of the members, LVI Group Investments, LLC (“LVI”), owned 62.5% of NorthStar, while the other member, NCM Group Holdings, LLC (“NCM”), owned 37.5% of NorthStar. Pursuant to the merger agreement (the “Merger Agreement”), LVI was required to submit to NCM consolidated financial statements of its subsidiaries (the “LVI Financial Statements”). After the Merger, certain LVI projects suffered losses and NCM made allegations that the LVI Financial Statements contained material misstatements. Eventually, LVI, not NCM, filed a complaint alleging fraud, fraudulent inducement, and unjust enrichment and pleading claims for indemnification and a declaratory judgment against NCM with respect to certain representations and warranties made by NCM in the Merger Agreement. NCM, in turn, filed a counterclaim pleading five counts against, among others, LVI and two of its officers, Scott State and Paul Cutrone (LVI, State, and Cutrone being collectively referred to herein as the “Counter-Defendants”). Counts I and II of the counterclaim consisted of claims for fraud and fraudulent inducement against the Counter-Defendants and NorthStar alleging that the Counter-Defendants knowingly made or caused to be made false representations of material facts in the LVI Financial Statements and knowingly misrepresented that the LVI Financial Statements were prepared in accordance with GAAP. Counts I and II also alleged that the Counter-Defendants concealed substantial losses that they knew would occur. Count III was a claim for indemnification against LVI arguing that LVI was required to indemnify NCM under the terms of the Merger Agreement in connection with losses suffered from the inaccurate representations and warranties. In Count IV, NCM asserted a direct claim against State and Cutrone, as officers of NorthStar, for breaching their fiduciary duties to NCM by, among other things, knowingly failing to follow GAAP, manipulating NorthStar’s financial statements, and manipulating costs and revenues of LVI projects. In Count V, NCM asserted a derivative claim on behalf of NorthStar alleging that State and Cutrone breached their fiduciary duties by intentionally failing to comply with GAAP and manipulating NorthStar’s financial statements.
The Counter-Defendants moved to dismiss certain counts of the counterclaim for failing to state a claim upon which relief could be granted. The Counter-Defendants first argued that Counts I and II failed to plead fraud with the requisite particularity. NCM’s fraud claims alleged that: (i) LVI and its agents made certain financial representations, (ii) those representations were made to NCM during the Merger negotiations, (iii) those representations have proved false or inaccurate, (iv) the Counter-Defendants knew that those representations were false or inaccurate when made, and (v) NCM reasonably relied on those representations to its detriment while LVI profited therefrom. The Court held that these allegations satisfied the particularity requirements. While the Court acknowledged that one of the required elements – knowledge and intent regarding the false or inaccurate representations – was pled with general averment, it held that this element need not be pled with particularity.
The Court then analyzed NCM’s allegations that State and Cutrone breached their fiduciary duties by using their positions as officers of NorthStar to conceal the fraud described in Counts I and II. The Court granted the Counter-Defendants’ motion to dismiss Count IV because NCM failed to plead a direct claim. The Court cited El Paso Pipeline GP Co., L.L.C. v. Brinckerhoff, in which the Delaware Supreme Court stated:
“whether a claim is [direct or derivative] must turn solely on the following questions: (1) who suffered the alleged harm (the corporation or the suing stockholders, individually); and (2) who would receive the benefit of any recovery or other remedy (the corporation or the stockholders, individually)? In addition, to prove that a claim is direct, a plaintiff must demonstrate that the duty breached was owed to the stockholder and that he or she can prevail without showing an injury to the corporation.”
The Court held that Count IV’s allegations that State and Cutrone, as officers of NorthStar, tried to conceal fraud was direct harm to NorthStar and the requested relief – removal of State as an officer of NorthStar – would benefit NorthStar, not just NCM. According to the Court, the benefit of removing an officer alleged to have breached fiduciary duties ran to NorthStar directly, and only indirectly to NorthStar’s members.
The Court then dismissed the derivative claim in Count V because NCM failed to adequately allege demand futility. The Court looked to Delaware corporate law for the standards to apply to a derivative claim in the LLC context. The Court noted that it is a fundamental tenet of Delaware corporate law that the board of directors, not the stockholders, manage the business and affairs of the corporation. As such, if a stockholder believes that an officer of a corporation is breaching his or her fiduciary duties and wants to bring a derivative suit against such officer, the stockholder must first make a demand that the board of directors pursue the cause of action. Demand is unnecessary if the stockholder can demonstrate that the board of directors would be incapable of acting in the corporate interest, thus making demand futile. A fact-intensive, director-by-director analysis is required to meet the pleading standard for demand futility.
Here, the Court found that NCM made cursory allegations that fell short of the particularity requirements. NCM alleged, for instance, that seven of the eleven board members of NorthStar were former managers of LVI who, except for one, had ownership interests in LVI. Referring to one broad group of seven board members and claiming that they have an interest in LVI and stand to personally benefit from the actions of State and Cutrone does not constitute a fact-intensive, director-by-director analysis required to plead demand futility. According to the Court, in order to adequately plead demand futility, NCM needed to describe the facts of the alleged interest and how it was material to each such director.