Delaware Court Of Chancery Applies Contemporaneous Ownership Requirement And Declines To Extend Equitable Derivative Standing
On May 13, 2022, Chancellor Kathaleen St. J. McCormick of the Delaware Court of Chancery dismissed certain stockholder derivative claims for breaches of fiduciary duty brought against the founder-CEO and other directors of Flashpoint Technology, Incorporated (the “Corporation”). SDF Funding LLC v. Fry, C.A. No. 2017-0732-KSJM (Del. Ch. May. 13, 2022). Plaintiffs were a limited liability company (the “New LLC”) that held shares in the Corporation and its sole owner (the “Beneficial Owner”). The New LLC received its shares from another limited liability company (the “Old LLC”) — a nonparty to the suit — also wholly owned by the Beneficial Owner. Plaintiffs challenged certain related-party transactions, including leases from and loans to entities affiliated with the CEO. Applying the “contemporaneous ownership requirement,” the Court granted summary judgment to defendants for claims based on conduct that predated the acquisition of shares by the New LLC. In doing so, the Court rejected plaintiffs’ contention that the Beneficial Owner should have “equitable standing.”
The Beneficial Owner invested in the Corporation through the Old LLC in 1999 and caused the Old LLC to transfer the shares to the New LLC in March 2015. Some of the challenged conduct occurred before March 2015.
As the Court explained, the “contemporaneous ownership requirement” under Section 327 of the Delaware General Corporation Law provides that a stockholder “must hold stock at the time of the alleged wrong to have standing to pursue a derivative claim.” The Court noted that it had been “persuasively argued that the contemporaneous ownership argument lacks justification” and “calls out for reexamination,” but concluded that “Section 327 is the law, which the court is bound to apply.” Therefore, the Court dismissed the claims asserted by the New LLC to the extent they challenged conduct before March 2015.
The Court declined to grant derivative standing to the Beneficial Owner for any claims, notwithstanding that he was the sole owner of both the Old LLC and the New LLC. Plaintiffs argued that the Court “should look through” the LLCs under the “equitable standing doctrine.” But the Court noted that the doctrine applies “to prevent a complete failure of justice on behalf of the corporation.” The Court explained that “the analysis looks to the rights of the corporation or residual claimants as a whole and not any individual plaintiff.” Thus, courts have “declined to extend the doctrine … where other avenues for invoking judicial machinery exist in theory because other potential plaintiffs would have standing to pursue the claims at issue.” The Court concluded that, “[i]n this case, there are not structural impediments to the pursuit of derivative claims” because other stockholders have standing.
In addition to deciding the motion for summary judgment, the decision also addressed a motion to dismiss certain claims that plaintiffs added in an amended complaint after receiving discovery, including claims related to compensation made by the Corporation to the CEO and his sons who were part-time employees. Defendants moved to dismiss the compensation claims under Court of Chancery Rule 23.1 for failure to plead demand futility.
The board of the Corporation at the time that the amended complaint adding these compensation-related claims was filed comprised the CEO and two other directors. Defendants conceded that the CEO was interested in the challenged transactions. The Court found plaintiffs had alleged facts sufficient to demonstrate a reason to doubt another director’s ability to “impartially consider a demand to sue” the CEO. The Court highlighted that the director “live[s] in the same small town” and had “known and collaborated with” the CEO for 30 years — involving business partnerships and civic interests — and received substantial financial benefits from their relationship. Therefore, the Court denied the Rule 23.1 motion to dismiss.
The Court also denied defendants’ motion to dismiss for failure to state a claim. The Court noted that it had already concluded that the CEO was interested and that one of the other directors lacked independence from the CEO. As there were only four directors as the time of the alleged payments, the Court found that plaintiffs had “carried their burden of rebutting the business judgment rule” and thereby invoking “entire fairness” review. The Court also declined to dismiss unjust enrichment claims related to the compensation, as well as claims for alleged breaches of fiduciary duty with respect to allegations that defendants usurped corporate opportunities in connection with investments by entities affiliated with the CEO that operated out of properties leased by the Corporation.