Delaware Court of Chancery on waste and fiduciary duties

The Delaware Court of Chancery has held that an alleged misallocation of consideration in a sale of assets may constitute waste. The case is important not only because it is one of the few that suggests the possibility of actually finding waste but because it also tacitly acknowledges the change in Delaware law that Stone v. Ritter brought about.

In Bakerman v. Sidney Frank Importing Co., Inc., Bakerman was the chief counsel for SFIC, which owned half an LLC that owned a French entity, SAS, that made Grey Goose Vodka. The remaining interest in the LLC was owned by SFIC insiders, including Bakerman. Those insiders, but not Bakerman, also owned SFIC stock.

Unbeknownst to Bakerman, other SFIC insiders negotiated the sale of assets of SAS, the LLC, and SFIC to Bacardi. The agreement required the approval of all owners of the LLC. The consideration was cash with an earn-out. The purchase agreement allocated over 99.5% of the consideration to SFIC and less than half of one percent to SAS. Bakerman balked at the allocation and refused to consent to the transaction; he relented under pressure. Three weeks later he was terminated and brought this action for tort, breach of contract, and breach of fiduciary duties. Bakerman did not make prior demand on the LLC’s managers, who moved to dismiss on several grounds.

Chancellor Chandler allowed most of the suit to proceed. Two aspects of his opinion are noteworthy. First, in applying the Aronson test for demand futility, the Chancellor found that the transaction might constitute waste, thus raising a reasonable doubt that the allocation decision was the product of a valid exercise of business judgment.

This strikes me as an unusual willingness to look at the substance of a transaction and suggests that the facts might sustain a claim of waste. On the one hand, this case is at the 12(b)(6) stage so there is no definitive finding of waste. However, the Chancellor found that Bakerman met both aspects of Aronson’s first prong, meaning the LLC managers were arguably interested and not independent. The facts upon which that finding were made are relatively clear. Having found the first Aronson prong met, there would seem to be no reason to reach out to make a statement about the possibility of waste unless the Chancellor wanted to highlight the possibility of the Delaware courts’ becoming more active in this area. This seems particularly noteworthy in light of the Disney finding of no waste.

The second noteworthy finding is a silent acknowledgment of Stone v. Ritter. In articulating the second Aronson prong, Chancellor Chandler wrote,

[T]he managers of an LLC are presumed to have acted on an informed basis and in the honest belief that the decisions were in furtherance of the best interests of the LLC and its members.

Note the absence of “good faith” in this incantation. Traditionally, directors’ fiduciary duties are described as the obligation to act “on an informed basis, in good faith, and in the honest belief. . .”. After Stone, we know good faith is a subset of the duty of loyalty so Chancellor Chandler’s formulation is apparently the new statement of fiduciary duties.

There may be a sly back story to this. As academics and the Delaware courts were trying to figure out whether good faith was a separate duty, some judges were engaging in subtle disobedience. In 1996, three years after the Supreme Court emphasized that there is a triad of fiduciary duties, Vice Chancellor Steele quoted Aronson but left out “, in good faith,” without indicating the omission. A few years later Vice Chancellor Noble followed suit. Those cases were, of course, pre-Stone. Bakerman is the first post-Stone case that describes a dyad of duties. It will be interesting to see whether this becomes the standard description and whether any opinion will acknowledge the change.

Francis Pileggi (link) has a more detailed description of Backerman.