United States: Applying Delaware’s Direct vs. Derivative Analysis To Contract Claims

Last Updated: December 11 2014
Article by Karen Clarke

In NAF Holdings, LLC v. Li & Fung (Trading) Limited, 2014 WL 6462825 (2d Cir. Nov. 19, 2014), the Second Circuit considered, but did not decide, whether the usual direct/derivative analysis governing minority stockholder claims against corporate fiduciaries should also apply to bar a contract claim against an unaffiliated outsider.  Finding itself unable to resolve this issue of first impression under applicable Delaware law, the Second Circuit certified the question to the Delaware Supreme Court.

This unusual question arose after a planned acquisition fell through.  NAF, a Delaware LLC, planned to acquire Hampshire.  NAF entered into a buying agent agreement with Li & Fung, which promised to serve as sourcing agent for Hampshire post-acquisition.  Thereafter, as is commonly done in M&A transactions, NAF formed two wholly-owned subsidiaries to effectuate the acquisition, and they entered into the merger agreement with Hampshire.  As NAF alleged in its complaint for breach of contract, Li & Fung wrongfully repudiated the buying agent agreement, which caused NAF to lose the financing commitments it needed to fund the subsidiaries' acquisition of the Hampshire shares.  The acquisition thus could not be completed, resulting in a $30 million loss.

Li & Fung moved to dismiss on the ground that NAF could not assert this breach of contract claim directly because it, as a stockholder of the NAF subsidiaries, could only sue derivatively on behalf of the subsidiaries that suffered the direct loss.  The District Court (Judge Paul Engelmayer, S.D.N.Y.) agreed, applying the standard established by the Delaware Supreme Court in Tooley v. Donaldson, Lufkin & Jenrette, Inc., 845 A.2d 1031, 1036 (Del. 2004).  In Tooley, the Court announced that determining whether a stockholder's claim is derivative or direct "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)?"  Judge Engelmayer found that the claim was necessarily derivative because any injury to NAF resulted from injury to its subsidiaries.

The Second Circuit panel was uncertain whether the Tooley standard should be applied to this contract suit, which presented a "very different scenario" from the ordinary shareholder suit alleging that corporate insiders breached their fiduciary duties.  As the majority (Judge Pierre Leval) explained, NAF's claim was based on a contractual duty owed directly to it by the defendant, and such a party generally may sue to remedy a breach of a contractual commitment.  The purpose of the rule requiring stockholders to sue derivatively is "to protect the separate integrity of the corporation, distinct from its shareholders," but that goal may not be served by preventing a 100% shareholder from suing directly.  Also, it makes little sense to allow the direct/derivative bar to be raised by a stranger to the corporation, which "has no cognizable interest in the protection of the corporation's power to make decisions independent of its shareholder."  On the other hand, as the concurring Judge (Gerard Lynch) believed, basic principles of corporate separateness suggest that even when the claim is based upon a contract duty, "there is something anomalous about allowing one corporation to bring a suit based on damages that accrue directly to a different corporation in which it owns a stake."

Finding no Delaware law addressing the applicability of the established direct/derivative analysis to this type of case, the Second Circuit sought the guidance of the Delaware Supreme Court.  It certified the question, "[M]ay the promisee-plaintiff bring a direct suit against the promisor for damages suffered by the plaintiff resulting from the promisor's breach," or may the plaintiff, as a shareholder, "enforce the contract only through a derivative action brought in the name of the third-party beneficiary corporation?"  It will be interesting to see what answer the Delaware Supreme Court provides, and whether it will affect practitioners' structuring of merger transactions.

A more detailed discussion of the NAF decision appears in the December 10, 2014 New York Law Journal.

Applying Delaware's Direct vs. Derivative Analysis To Contract Claims

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