Fiduciary Duty of Disclosure Does Not Apply to Individual Transactions with Equityholders

Matthew Greenberg and Joanna Cline are partners, and Taylor Bartholomew is an associate at Pepper Hamilton LLP. This post is based on a recent Pepper memorandum by Mr. Greenberg, Ms. Cline, Mr. Bartholomew, and Christopher B. Chuff. This post is part of the Delaware law series; links to other posts in the series are available here.

In Dohmen v. Goodman, the Delaware Supreme Court declined to impose an affirmative fiduciary duty of disclosure on a general partner arising out of the general partner’s solicitation of capital contributions from a limited partner where the general partner knowingly made misrepresentations in the process. The court’s decision provides a comprehensive roadmap not only for general partners in assessing the scope of their fiduciary duties when communicating with limited partners under Delaware law, but also corporate fiduciaries more generally.

Background

In 2010, Bert Dohmen formed Croesus Fund, L.P. (the Fund) as a Delaware limited partnership with the intention of starting a hedge fund. Dohmen also formed Macro Wave Management, LLC to serve as the Fund’s general partner. In 2011, Albert Goodman made an initial capital contribution in the Fund and became a limited partner. During the same year, Dohmen himself also invested in the Fund. Following Goodman’s investment, Goodman inquired several times as to whether there were other investors in the Fund. Dohmen stated that he had several friends who were liquidating assets in order to participate in the Fund, but, according to the court, no friends of Dohmen’s were actually doing so and Dohmen was aware of this. In 2011, Goodman again invested in the Fund. Dohmen represented to Goodman that his friends were interested in the Fund and were reviewing certain investment documents, which the court characterized as a knowingly false statement. In 2012, Dohmen informed Goodman for the first time that there were only two investors in the Fund. Dohmen offered to allow Goodman to withdraw his investments, but Goodman declined. By 2014, the net asset value of the Fund declined to $100,000. Goodman did not receive a return of any portion of his investment.

In 2015, Goodman filed suit in the U.S. District Court for the Central District of California against Dohmen, alleging common law fraud, securities fraud and breach of fiduciary duty. The district court ruled against Goodman on the fraud and securities claims, finding that, at the time of Goodman’s second investment, Dohmen misrepresented the Fund’s actual number of investors to Goodman, Dohmen did so with “knowledge and scienter,” and Goodman relied on the misrepresentation, but holding that Goodman ultimately failed to satisfy causation (which is required for successful fraud and securities law claims).

The district court found for Goodman with respect to his fiduciary duty claim, noting that, when Goodman was considering his second investment in the Fund, Dohmen made a misrepresentation “when seeking limited partner action” and that, consequently, under Delaware law, Goodman was not required to prove reliance or causation to support his breach of fiduciary duty claim. Accordingly, the district court awarded Goodman compensatory damages. Dohmen appealed to the U.S. Court of Appeals for the Ninth Circuit. After rejecting all of Dohmen’s other arguments, the Ninth Circuit certified the following question [1] to the Delaware Supreme Court to resolve the Ninth Circuit’s final issue on appeal:

Under the stipulated facts of this dispute, does the general partner’s request to the limited partner for a one-time capital contribution constitute a request for limited partner action such that the general partner has a duty of disclosure, and if the general partner fails to disclose material information in connection with the request, may the limited partner prevail on a breach of fiduciary duty claim and recover compensatory damages without proving reliance and causation?

Court’s Analysis

Responding in the negative to the first part of the question, the court held that Dohmen did not owe Goodman a duty of disclosure because Dohmen’s request for the capital contribution did not constitute a request for limited partner action. In arriving at its decision, the court noted that the Fund’s limited partnership agreement did not disclaim the fiduciary duty of loyalty, meaning that the general partner assumed fiduciary duties equivalent to those of directors of a Delaware corporation. The court began its analysis with the fundamental principle that a director’s disclosure obligations are context-dependent. When a director requests stockholder action, the duty of disclosure applies and the director must disclose fully and fairly all material facts within his or her control that bear on the request. A breach of the fiduciary duty of disclosure enables a stockholder to seek equitable relief or damages without being required to prove reliance, causation or damages. By contrast, the fiduciary duty of disclosure does not apply when a director communicates with stockholders and is not requesting stockholder action. In this latter context, a director must deal honestly with stockholders and refrain from knowingly disclosing false information under the director’s fiduciary duties of care and loyalty. To state a claim for breach of fiduciary duty in this context, a plaintiff must establish reliance, causation and damages.

Relying on a line of Delaware case law originating from the court’s decision in Malone v. Brincat, the court declined to impose an affirmative fiduciary duty of disclosure for individual transactions. The court reasoned that the fiduciary duty of disclosure is necessary in the context of calls for stockholder action in the aggregate because of a collective action problem—it simply may not be practical or possible for each stockholder individually to ask the corporation its own questions regarding the decision presented. In an individual transaction, however, an individual stockholder may refuse to take action until it is satisfied that the corporation has given it sufficient information to evaluate the decision presented. With respect to Goodman, the court found that he had direct access to the information necessary to explore his investment in the Fund, including a private placement memorandum and email communications with Dohmen regarding the capital contributions. Thus, the court held that Dohmen did not owe a fiduciary duty of disclosure to Goodman. Instead, the court held that Dohmen had breached his fiduciary duty of loyalty when he knowingly misrepresented to Goodman the number of investors interested in the Fund. However, according to the court, Goodman could not recover damages from Dohmen because Goodman’s damages claim had failed in the district court for lack of causation. [2]

Takeaways

The court’s decision in Dohmen is a helpful roadmap for fiduciaries and their counsel seeking to better understand the contours of the duty of disclosure. Dohmen makes clear that fiduciaries only owe a duty of disclosure to equityholders when soliciting equityholder action [3] and that transactions with individual equityholders do not constitute a solicitation for equityholder action. In the context of individual transactions with equityholders, however, fiduciaries must still communicate honestly and fairly with the equityholders as the duties of loyalty and care still attach (albeit with heightened pleading requirements). As a practical matter, in addition to relying on those fiduciary duties, individual stockholders can also rely on contractual representations made by the entity in any such transaction and recover for breach of contract and common law fraud in the instance of any affirmative misrepresentations made to them.

Endnotes

1At the invitation of the Ninth Circuit, the court reframed the certified question as set forth here.(go back)

2The court also held that damages flowing from a breach of the duty of disclosure are, by default, nominal. According to the court, even if Dohmen owed a fiduciary duty of disclosure to Goodman, Goodman would still need to prove reliance and causation to recover compensatory damages.(go back)

3We note that the Delaware Court of Chancery has held that certain disclosure obligations apply when providing notice of action by non-unanimous written consent of stockholders under section 228(e) of the Delaware General Corporation Law (DGCL). Specifically, in Dubroff v. Wren, C.A. No. 3940-VCN (Del. Ch. May 22, 2009), the court held that a notice sent pursuant to section 228(e) of the DGCL that omitted certain material facts regarding who benefitted from the underlying transaction and what the benefits the individuals received was, at minimum, materially misleading for purposes of a motion to dismiss. The court specifically noted that it was immaterial for purposes of the motion whether section 228(e) of the DGCL requires full disclosure of all material information as in the context of a request for stockholder action.(go back)

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