Delaware Court of Chancery rejects argument that the distinction between direct and derivative claims is inapplicable in the context of a two-member LLC

7 July 2021 Reed Smith Client Alerts

Home Perspectives Delaware Court of Chancery rejects argument that the distinction between direct and derivative claims is inapplicable in the context of a two-member LLC

In Clifford Paper, Inc. v. WPP Investors, LLC, 2021 WL 2211694 (Del. Ch. Jun. 1, 2021), the Delaware Court of Chancery rejected an argument that the distinction between direct and derivative claims is irrelevant in a dispute between the members of a two-member LLC, and the court held that claims alleging wrongful disposition of corporate resources or assets were essentially derivative in nature, meaning that a former member of a two-member LLC lacked standing to assert such derivative claims and could not do so after failing to make a litigation demand or plead demand futility.

Authors: Brian M. Rostocki Benjamin P. Chapple

Case background

The plaintiff in Clifford Paper, Inc. v. WPP Investors, LLC, Clifford Paper, Inc. (CPI), formed World Pac Paper, LLC (WPP) in 2004 along with the defendants, WPP Investors, LLC (Investors) and its owners, Edgard L. Smith and Richard A. Baptiste (collectively, Defendants). WPP was a distributor of paper and packaging products and provider of printing, shipping and warehousing consignment services to commercial and retail clients. CPI and Investors owned 45 percent and 55 percent of WPP, respectively. Under WPP’s operating agreement (the Operating Agreement), CPI and Defendants shared management duties of WPP – specifically, Smith, Baptise, and CPI’s president John Clifford were designated as WPP managers. CPI separately performed services for WPP.

CPI and Investors remained the only two members of WPP until 2018, when CPI withdrew from WPP after relationships between the parties deteriorated. CPI initiated the lawsuit in the Delaware Court of Chancery in 2020, alleging various breaches of the Operating Agreement, including that it had been disenfranchised, and a breach of the fiduciary duty of loyalty. Among other things, CPI claimed Defendants breached the Operating Agreement by hiring a family member to a lucrative position within WPP that would perform duties already held by CPI, cancelling CPI’s contract with WPP, excluding CPI’s management designee from key decisions, and diverting business to Investors. Defendants moved to dismiss the theory that CPI lacked standing because its claims were derivative and that, under Section 18-1001 of Delaware’s Limited Liability Company Act (the Delaware LLC Act), former members do not have standing to bring derivative claims.

At the threshold, CPI insisted that it brought direct (as opposed to derivative) claims because it was challenging wrongful acts that have denied CPI rights under the Operating Agreement to vote on key decisions affecting WPP. CPI also argued that the Tooley two-part test—which differentiates between direct and derivative claims—could not apply because WPP was a two-member limited liability company, and the Tooley test ignores the reality that harm to the limited liability company caused by one member flows directly to the other member. The Tooley test asks whether (i) the company or the individual suffered the harm, and (ii) the company or the individual would receive the benefit of any remedy.

The court’s analysis

The court rejected CPI’s proposed distinction between the case at hand and Tooley, and concluded that the claims brought by CPI were derivative. The court noted that the Delaware LLC Act does not recognize an exception for two-member companies when discussing the requirements for derivative actions, and the precedents CPI relied upon to suggest otherwise were inapt, as they involved dissolved companies, or other circumstances where a plaintiff with standing properly brought derivative claims, but the court reasoned a remedy might flow directly to investors.

The court explained that, in most instances, the denial of the franchise will cause direct harm to the owner, but that is not always the case. When classifying a claim as direct or derivative, Delaware courts focus not on the nature of the wrong but the nature of the alleged harm flowing from the wrong.

Here, the court determined that the harm, if any, flowing from the alleged wrongful conduct directly affected WPP, not CPI. Specifically, CPI argued it would not have approved of (i) creating a new, lucrative executive position for a relative of one of Defendants, and (ii) hiring a new financial advisor. The court reasoned, however, that CPI alleged such actions resulted in financial harm to WPP, for which CPI sought compensatory damages. CPI’s claims, therefore, were derivative, not direct. Because CPI withdrew from WPP before initiating the lawsuit, and was therefore not a member of WPP when it brought the claims, CPI lacked standing to pursue such claims. CPI also did not, in any event, make a demand on the WPP board to pursue the claims, or attempt to plead demand futility. For those reasons, the court granted Defendants’ motion to dismiss in full.

Key takeaways

A member of a Delaware limited liability company loses standing to assert derivative claims on behalf of the company when it surrenders its membership interest.
As in any other context, Delaware courts will apply the Tooley two-part test for distinguishing between direct and derivative claims in the context of a two-member limited liability company.
When classifying a claim as direct or derivative, Delaware courts look past complaints labeling of claims, and focus not on the nature of the wrong but the nature of the alleged harm flowing from the wrong.

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