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Trustee’s Claims Against Insiders For Their Action (or Inaction) in the Face of Insolvency Survives Motion to Dismiss Despite Exculpation, Business Judgement, and Deeping Insolvency Defenses

Stanziale v. Versa Capital Mgmt., LLC (In re Simplexity, LLC), Case No. 14-10569 (KG), 2017 WL 65069 (Bankr. D. Del. Jan. 5, 2017)

According to the Chapter 7 Trustee of Simplexity, LLC (“Simplexity” and together with its affiliated debtors, the “Debtors”), numerous insiders of Simplexity (the “Defendants”) breached their fiduciary duties by refusing to seek bankruptcy protection for Simplexity when faced with actions by Simplexity’s lender, including the threat to sweep all available funds, thereby failing to preserve the value of the Debtors and exposing Simplexity to employment related claims.  In this Memorandum Opinion, the Delaware Bankruptcy Court resisted the Defendants’ arguments to dismiss the Trustee’s claims.

In requesting that the matter be dismissed, the Defendants argued that exculpation provisions contained within applicable limited liability company agreements as well as the business judgment rule shielded them from liability under Delaware law.  The Delaware Bankruptcy Court, however, sided with the majority of Delaware bankruptcy courts and declined to consider such affirmative defenses as bases for dismissal.  While at least one Delaware bankruptcy court has considered an exculpation clause at the motion to dismiss stage, Judge Gross distinguished that case, noting it was limited to violations of the fiduciary duty of care while the matter at hand also included charges of gross negligence and disloyalty.  But see, e.g., Blackmore Partners, L.P. v. Link Energy LLC, 864 A.2d 80, 85 (Del. Ch. 2004) (holding that to survive a motion to dismiss in Delaware state court, a complaint must allege particularized facts to buttress a conclusion that the defendant directors engaged in conduct not immunized by an exculpatory charter provision).  And while the Court of Appeals for the Third Circuit has held that the business judgment rule could serve as a basis for dismissal if it appears on the face of the complaint, Judge Gross held that the Trustee did not raise it in his complaint and therefore, did not give the Defendants the ability to raise the defense in their dismissal motion.  But see, e.g., Growbow v. Perot, 539 A.2d 180 187 (Del. 1988), overruled on other grounds by Brehm v. Eisner, 746 A.2d 244 (Del. 2000) (requiring plaintiff to allege specific facts to support a claim in Delaware state court for breach of fiduciary duty and to overcome the business judgment rule).

Failing to achieve dismissal based on exculpation and the business judgment rule, the Defendants next argued that the Trustee’s claims were really deepening insolvency claims, which are not proper under Delaware law.  As the Delaware Chancery Court has said, there is no absolute obligation imposed upon boards to shutter a company and liquidate if the company cannot pay its debts.  A failed strategy that results in a corporation’s deepened insolvency does not by itself constitute a proper claim.  Allegations of disloyalty or lack of due care in implementing the strategy are needed.  See, e.g., Trenwick Am. Litig. Trust v. Ernst & Young, L.L.P., 906 A.2d 168, 204-05 (Del. Ch. 2006).  In comparing those holdings to the Trustee’s claims, however, Judge Gross did not find a basis to dismiss.  As noted by the Court, “[i]t was the action or inaction in the face of insolvency itself, not deepening insolvency, that the Trustee complains about.  Was it gross negligence, disloyalty, or disregard of the law that resulted in Defendants’ inaction”?  Op. at 18-19.  This question will need to be answered now that the Trustee’s claims have moved to the next stage of litigation.

[Update - Following the ruling, the defendants filed their answers, attached copies of the applicable LLC Agreements (which were incorporated by reference in the Trustee’s Complaint), raised affirmative defenses based on exculpation, and submitted FRCP 12(c) motions for judgment on the pleadings.  On June 1, 2017, Judge Gross held that the exculpation provisions contained in the LLC Agreements could be properly considered as a basis for dismissal on a Rule 12(c) motion, but ultimately determined that the Trustee’s claims were not eliminated as the governing exculpation provision preserved causes of action for breach of duties of loyalty, good faith, and fair dealing.  See Stanziale v. Versa Capital Mgmt., LLC (In re Simplexity, LLC), No. 16-50212 (KG), 2017 WL 2385404 (Bankr. D. Del. June 1, 2017).]