Delaware Law Watch

Background
On August 28, 2024, the Delaware Court of Chancery issued a post-trial final report in Peneff Holdings LLC v. Nurture Life, Inc., which addressed the circumstances where a stockholder may waive its right to inspect a corporation’s books and records under DGCL § 220. Nurture Life, Inc.’s (the “Company”) Investors’ Rights Agreement (the “IRA”) required it to deliver to each “Major Investor” certain categories of information within specified time periods. Plaintiff Peneff Holdings LLC (“Peneff”) was initially a Major Investor under the IRA. However, the Company amended the IRA (the “Amended IRA”), which stated that an investor ceased to be a “Major Investor” if the investor or its affiliates engaged in any legal action against the Company. Since one of Peneff’s non-stockholder affiliates was engaged in separate litigation against the Company, the Company took the position that Peneff was no longer a qualifying Major Investor and thus no longer had any inspection rights under the Amended IRA.

The Company contended that Peneff waived its statutory inspection rights because the intent of the inspection rights in the Amended IRA was to supplant all other sources of information rights, including DGCL § 220. The Court held that the Amended IRA was not a waiver of Peneff’s statutory inspection rights.

The Delaware Court of Chancery’s Decision
Setting aside the question of whether a stockholder can waive its statutory inspection rights in a private contract under Delaware law, the Court found that the Amended IRA provided that “a Major Investor is contractually entitled to information; it does not say the inverse—that a stockholder who no longer qualifies as a Major Investor forfeits other information rights.” Thus, the Amended IRA did not “clearly waive Peneff’s statutory inspection rights.”

Takeaway for Practitioners

• While it is unsettled whether a stockholder can waive its statutory inspection rights in a private contract under Delaware law, practitioners should note that any attempt at such a waiver must be clearly stated.

Background
On September 27, 2024, the Delaware Superior Court issued a ruling in Wellgistics, LLC v. Welgo, Inc., which addressed a parent entity’s failure to enforce its subsidiary’s contracts. Welgo, Inc. (the “Parent”) generated revenue through its subsidiary Welgo, LLC (the “Subsidiary”). Due to the Subsidiary’s business, it kept its list of medications and distributors confidential. Shortly after the formation of the Parent, one of its founders sought to sell 50% of the Parent’s Stock to Wellgistics, LLC (“Wellgistics”). During diligence, Wellgistics requested information about the Subsidiary’s products and business. The Parent refused to disclose anything until the parties executed a Mutual Confidentiality Agreement (“MCA”). Once the parties executed the MCA, Wellgistics learned of the identity of the Subsidiary’s medications and distributors.

Thereafter, Wellgistics began purchasing large quantities of the medications that the Subsidiary normally bought and contacted its distributors. The Parent alleged Wellgistics’ actions increased national utilization rates and triggered unwanted scrutiny. As a result, the medications that the Subsidiary normally sold were no longer fully covered by insurance. This reduced the number of medications that the Subsidiary was able to sell, decreasing the Parent’s profit. The Parent—not the Subsidiary—filed suit against Wellgistics for breach of the MCA and for tortious interference.

The Delaware Superior Court’s Decision
Breach of Contract
The Court found that Wellgistics had a duty to only use the confidential information it received under the MCA for the purchase of the Parent’s stock. However, Wellgistics only owed that duty to the Subsidiary—not the Parent. Under Delaware law, a parent entity generally “does not have a claim for improper disclosure of confidential information belonging to a subsidiary.” Here, the Parent alleged disclosure of the Subsidiary’s confidential information—not the disclosure of the Parent’s confidential information. Thus, the Court held that the Parent failed to plead a claim for breach of the MCA.

Tortious Interference
The Parent argued that it was a third-party beneficiary of the Subsidiary’s contracts with its distributors because it wholly-owned the Subsidiary and the Subsidiary was operated for the benefit of the Parent. The Court disagreed. Under Delaware law, a parent entity is not automatically a third-party beneficiary of its subsidiary’s contracts. Further, the fact that the Subsidiary paid some of its revenue to the Parent, made the Parent, at most, an incidental beneficiary; not enough to support a tortious interference claim.

Takeaways for Practitioners

• Under Delaware law, parent entities generally do not have a claim for improper disclosure of confidential information belonging only to a subsidiary, absent clear contractual language providing the parent this right. 
• The fact that a parent entity wholly-owns its subsidiary and receives portions of the subsidiary’s revenue does not automatically make the parent entity a third-party beneficiary to a subsidiary’s contract(s).  

Background
On August 21, 2024, the Delaware Court of Chancery issued an Order in Potts v. SYFS Intermediate Holdings, LLC which addressed the failure to impose implied obligations in the face of clear contractual language. SYFS Intermediate Holdings LLC (“SYFS”) adopted an LLC Agreement that stated managers owe “no fiduciary duties (including duties of care and loyalty) to [SYFS] and the members.” Although the LLC Agreement eliminates fiduciary duties, it does not by its terms and cannot under the Delaware LLC Act eliminate the implied contractual covenant of good faith and fair dealing. Plaintiffs Sybill Potts and others (“Potts”) were unit holders and filed suit against SYFS, challenging its asset sale. Potts alleged that SYFS violated the implied covenant of good faith and fair dealing by obtaining income outside of the LLC Agreement’s waterfall provision through the asset sale. Specifically, Potts argued that the waterfall provision provided the exclusive framework through which SYFS equity holders were to profit from SYFS. SYFS countered that Potts’ argument was “nothing more than a backdoor attempt to assert a claim for breach of fiduciary duty,” despite “an express provision in the [LLC Agreement] that eliminate[d] all fiduciary duties.”

The Court of Chancery’s Decision
The Court held that Potts’ implied covenant claim was nothing more than a backdoor attempt to assert breach of fiduciary duty claims—despite an express provision eliminating such claims. Under Delaware law, the implied covenant of good faith and fair dealing “cannot be used to circumvent the parties’ bargain.” Here, the parties explicitly bargained for and agreed to a provision unequivocally eliminating all fiduciary duties. Thus, the Court dismissed Potts’ implied covenant claim.

Takeaway for Practitioners

• Delaware courts will seldom entertain arguments for breach of fiduciary duties with a limited liability companies where the parties explicitly eliminated them.

Background
Two Delaware decisions recently sustained implied covenant claims challenging the termination of at-will corporate officers. In Schatzman v. Modern Controls, Inc., a corporate officer (“Schatzman”) was contractually entitled to 10% of the net proceeds from a sale of his employer if the sale occurred during his employment. The Company terminated Schatzman after investigating several employee complaints against him for harassment and defamation; several months later, the company announced a sale. Schatzman claimed that his termination violated the implied covenant of good faith and fair dealing, notwithstanding his status as an at-will employee, because, he alleged, the company terminated him in bad faith for the “improper purpose” of depriving him of his share of the sale proceeds. Denying the employer’s motion to dismiss, the Superior Court found that Schatzman sufficiently alleged that his employer terminated him for an improper purpose because, before his termination, his employer did not give him information about the accusations against him, no opportunity to participate in the investigation, and no forum to defend himself.

Roth v. Sotera Health Co. concerned a dispute about a former corporate officer’s (“Roth”) unvested equity units in his employer (the “Company”). The units were to vest if the Company’s private equity sponsor received cash distributions equal to a specified return rate on their investment; however, the units would be forfeited if they remain unvested when Roth’s employment ended. Roth resigned after receiving a demotion, and sued the Company for the value of his equity. Roth argued that the Company violated the implied covenant of good faith and fair dealing by constructively terminating him in bad faith to cause a forfeiture of his equity. The Court of Chancery sided with Roth and denied the Company’s motion for judgment on the pleadings.

Delaware courts are generally hesitant about recognizing the implied covenant in at-will employment contracts, but they recognize an exception where the employer “uses its superior bargaining power to deprive an employee of compensation that is clearly identifiable and is related to the employee’s past services.” The Court found that Roth sufficiently plead bad faith based on his allegations that the Company’s CEO “felt that [his] equity package was excessive and manufactured reasons for his demotion to avoid paying him for it” and that the company’s board of directors “took no efforts towards meeting the vesting conditions.”

Takeaways for Practitioners

• Delaware courts are hesitant to recognize implied covenant claims in the context of an at-will employment contract but may do so “where the employer used its superior bargaining power to deprive an employee of clearly identifiable compensation related to the employee’s past service” (as in Sotera) or “where the employer falsified or manipulated employment records to create fictious grounds for termination” (as in Schatzman).
• Bad faith may arise when a corporate officer is terminated in circumstances that suggest the company was motivated by a desire to avoid paying a benefit tied to the officer’s continued employment.

Background
On September 23, 2024, the Court of Chancery issued a ruling in Roth v. Sotera Health Co., which addressed a compensation dispute between an officer and his former employer relating to his unvested equity.

Plaintiff Kurtis Roth (“Roth”) was a former officer of Defendant Sotera Health Company’s (“Sotera”) operating subsidiary, as well as a member of Sotera holding Class B-2 Units. Pursuant to Sotera’s limited liability company agreement (the “LLC Agreement”), Class B-2 Units would vest if Sotera’s private equity sponsors received a specified multiple on their investment. However, any Class B-2 Units that remained unvested at the time Roth’s employment was terminated would be forfeited.

In 2016, Sotera was converted to a limited partnership and its limited partnership agreement (the “L.P. Agreement”) retained the same vesting and forfeiture term for Class B-2 Units set forth in the LLC Agreement.

In 2020, Sotera became a public corporation, and Roth executed a restricted stock agreement (the “RSA”) pursuant to which Roth’s Class B-2 Units were exchanged for restricted shares of common stock (the “Restricted Stock”). Notably, the RSA incorporated the terms of the L.P. Agreement by reference, generally providing unvested shares of Restricted Stock would be subject to the same vesting and forfeiture restrictions that applied to unvested Class B-2 Units.

In 2022, Roth resigned and was advised that his unvested shares of Restricted Stock would be forfeited. Roth then filed this action.

The Chancery Court’s Decision
On summary judgment, the Court held that the pre-IPO vesting and forfeiture terms applied to the Restricted Stock Roth received in exchange for his Class B-2 Units. The Court noted that the terms of the LLC Agreement were “carefully revised” into the L.P. Agreement when Sotera converted from a limited liability company to a limited partnership. Specifically, the Court highlighted that the defined terms in the LLC Agreement matched those in the L.P. Agreement. The RSA, on the other hand, “simply incorporate[d] the terms of the [L.P. Agreement] by reference.” The Court highlighted that this practice created several “ill-fitting” terms. Nevertheless, the Court found that “sloppy drafting does not necessarily create ambiguity.”

Despite the RSA’s “imperfect[ions],” the Court held that the LLC Agreement’s vesting and forfeiture terms, which “carried forward in identical provisions” in the L.P. Agreement, “continue[d] to apply to Roth’s unvested Sotera stock” through the RSA’s “clear incorporation provision,” which expressly stated those terms were “incorporated herein by reference as if fully set forth herein.” Accordingly, any shares of Restricted Stock that were unvested when Roth left Sotera were “forfeited and cancelled for no consideration.”

Finally, the Court rejected Roth’s argument that the incorporation failed under 8 Del. C. § 202(a) because the restrictions on his shares were not “contained in the notice or notices” provided with the stock grant. Section 202(b) allows restrictions to be imposed “by an agreement . . . among . . . security holders . . . and the corporation,” and Section 202(a) includes an exception for “persons with actual knowledge of the restriction.” Thus, the Court found that Roth had “signed and consented to the [RSA], which incorporate[d] vesting and forfeiture provisions he had been aware of since 2015.”

Takeaways for Practitioners

• When incorporating another instrument by reference, Practitioners should consider whether any of the terms to be incorporated (especially defined terms) are “ill-fitting” for the instrument interpreting them. For example, avoid incorporating terms by reference from an earlier instrument that refer to an entity as the “Partnership” into a later contract if the entity has since been re-organized into a limited liability company or a corporation.
• Even if “sloppy drafting does not necessarily create ambiguity” in a contract, it may still invite otherwise avoidable litigation.