Whether a claim against company management is direct or derivative is not infrequently disputed in litigation before the Delaware Court of Chancery. This determination becomes important in many contexts, including whether it was necessary for plaintiff to make a pre-suit demand upon the board, whether derivative claims of a company have been assigned to a receiver, or whether such claims have previously been settled in a prior litigation.
In the recent decision of Sehoy Energy LP, et al. v. Haven Real Estate Group, LLC, et al., C.A. No. 12387-VCG (Del. Ch. Apr. 17, 2017), the Court of Chancery examined the nature of the asserted claims due to the filing of bankruptcy of the entity for whom company management served. There, investors in a partnership commenced suit against a general partner and its principal, asserting that they breached the partnership agreement, induced plaintiffs to invest capital into the partnership, and breached their fiduciary duties by making decisions based upon self-interest.
After suit was commenced, the partnership, a non-party to the case, filed for bankruptcy. Plaintiff investors then filed a motion seeking a determination that their claims against the general partner and its principal should not be stayed by the bankruptcy. Defendants argued that the automatic stay applied to the action.
In considering the investors’ motion, Vice Chancellor Glasscock noted that if the action filed against the general partner was derivative in nature, then it would be stayed under the Bankruptcy Code because it would be an asset of the debtor’s estate. On the other hand, if the claims are direct, then they are not property of the partnership’s estate, and the Chancery litigation can move forward.
The Court found that certain of the investors’ claims were largely direct, and granted their motion. Relying upon the well-known Delaware Supreme Court decision of Tooley v. Donaldson, Lufkin & Jenrette, Inc. to determine whether the claims were derivative or direct, the Court examined “(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)?” 845 A.2d 1031, 1033 (Del. 2004). The Court found that the investors’ contract claims, breach of fiduciary duty claims, and fraud claims were all direct. Plaintiffs were willing to agree to forebear certain other claims while the automatic stay remains in effect.
The Court also declined to stay the action in the interest of judicial economy. Defendants asserted that wasteful overlap would occur between the action and the bankruptcy proceeding. However, because the parties indicated that no derivative claims would be brought before the bankruptcy court, there would be no likelihood of two separate courts entertaining two lawsuits based upon the same underlying dispute. Moreover, the Court noted that the elements and remedies surrounding the fraud and nondisclosure claims would be different than corporate mismanagement claims. Thus, Vice Chancellor Glasscock declined to stay the action in the interest of judicial economy.
Key takeaway: This is an important read for any party involved in litigation, in which a related non-party files for bankruptcy. In such a situation, Sehoy Energy provides a helpful roadmap in determining whether the pending Chancery action should be stayed or can proceed.