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Main image for Court of Chancery Holds that Sale of Shares Transfers Fiduciary Duty Claims to the Buyer in Dispute Between Founders and VC Fund
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Court of Chancery Holds that Sale of Shares Transfers Fiduciary Duty Claims to the Buyer in Dispute Between Founders and VC Fund

Delaware Law Update

9.19.2019

In Urdan, et al. v. WR Capital Partners, LLC, et al., the Delaware Court of Chancery held that the founders of a startup company lost standing to pursue breach of fiduciary duty claims against a venture capital fund after they sold their shares in the company, and that the founders did not adequately plead fraud claims against the venture capital fund. The decision contains important practice points for practitioners negotiating corporate disputes—namely, that by transferring shares of a company, the transferring stockholder also transfers breach of fiduciary duty claims associated with those shares to the buyer.

Case Background

The case involved a startup company called Energy Efficient Equity, which provides property assessed clean energy (PACE) financing for clean energy projects. In a PACE financing, a financial intermediary, such as Energy Efficient Equity, partners with a local municipality to lend money to property owners for energy-saving improvement projects, and the loan is repaid via assessments on the property owner’s property tax bill. In early 2016, WR Capital Partners, an investment fund, approached the founders of Energy Efficient Equity about making an investment in the company, and the parties ultimately closed the investment in May 2016. The investment took the form of a $5 million revolving line of credit from WR Capital to the company, and WR Capital received warrants from the company.  

The founders alleged that, in early 2017, WR Capital began using the line of credit to take over the company. The founders claimed that WR Capital first refused to approve further draws under the line of credit unless the founders agreed to various governance terms dictated by WR Capital. The founders alleged that WR Capital then used the negative covenants in the loan agreement governing the revolving credit line to block the company from seeking alternative sources of financing, forcing the company to accept additional capital from WR Capital on punitive terms that eventually resulted in WR Capital obtaining control of a majority of the company’s voting equity. During this time, WR Capital terminated the founders, installed a new CEO who was loyal to WR Capital, and engaged in additional interested transactions with the company, including a bridge financing.

In 2018, the company repurchased the founder’s shares as part of a negotiated settlement. The founders entered into a settlement agreement and release with WR Capital, the company, and other investors, and entered into repurchase agreements with the company pursuant to which the founders sold all their interests in their shares of the company back to the company. Notably, the settlement agreement and release sought to preserve the founders’ ability to bring claims against WR Capital by excluding such claims from the scope of the release.

Court of Chancery Decision

The founders asserted claims against WR Capital and its principals for breaches of fiduciary duty, fraud, and unjust enrichment. The Court of Chancery dismissed the breach of fiduciary duty claims, concluding that, regardless of whether such claims were direct or derivative in nature, the founders had lost standing to pursue them once they sold their shares. The court explained that, while the settlement agreement may have preserved those claims, the repurchase agreements effectively transferred ownership of the claims from the founders to the company (the buyer), because the claims were property interests that attached to the shares and were therefore transferred with the shares.

The court likewise dismissed the fraud claims against WR Capital and its principals. The founders alleged that WR Capital fraudulently induced the 2016 financing with misrepresentations that it “sought to work together as partners” and that it only sought minority ownership, when in fact WR Capital sought control. The founders also alleged that various statements from WR Capital and its principals regarding the size of their stake in the company were fraudulent in light of the alleged scheme to increase WR Capitals interest into a controlling stake in the company. The court’s decision dismisses these claims on the grounds that the statements in question constituted mere puffery or were duplicative of the breach of fiduciary duty claims (and therefore had been transferred with the sale of the shares). Although the opinion recites at length a series of alleged bad acts by WR Capital and its principals which, but for the founders’ lack of standing, might have given rise to colorable claims, the court declined to fashion an alternative remedy for the founders, reaffirming the high bar for pleading fraud claims under Delaware law.

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