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February 13, 2013

Ex-CEO Suffered No Harm Due to Breach, Awarded $1 in Damages

By Rodney F. Tonkovic, J.D.

The Delaware Chancery Court addressed the allegations of a minority unitholder in a privately held medical device company and concluded that while the director's breached the company's operating agreement, there was no breach of fiduciary duty. The directors' breach caused no damage, the court held, and the unitholder's requested relief was denied (Zimmeran v. Crothall, January 31, 2013, Parsons, D.).

The unitholder, Robert Zimmerman, is the co-founder and former CEO of the company, Adhezion Biomedical LLC (Adhezion). Zimmerman became a minority stakeholder after accepting investments in Adhezion in exchange for units and after selling some of his own units. Adhezion, which develops and commercializes medical adhesives, is managed by a board of directors under its limited liability company operating agreement.

According to the complaint in this derivative action, five directors caused the company to enter into four financing transactions that were in breach of the company's operating agreement. By undertaking these transactions, the directors allegedly breached their fiduciary duties. The challenged transactions included loans by the directors to the company in return for promissory notes and the issue of preferred units. Zimmerman alleged further that certain other unitholders breached their fiduciary duties and aided and abetted the directors' breach.

Breach of duty. Specifically, Zimmerman maintained that the directors breached their duty of loyalty by engaging in unfair, self-dealing transactions. He argued that the transactions should be analyzed under the entire-fairness standard of review because, at the time in question, two unitholders had actual control of the company and benefited from the transactions. In the alternative, he argued that at least a majority of the director defendants were interested in the transactions and benefited from them. Zimmerman also claimed that the directors breached the company's operating agreement by engaging in the financing transactions without obtaining the common unitholders' authorization.

The court first concluded that the director defendants breached the company's operating agreement by entering into the challenged transactions. This breach of contract claim was based on whether the operating agreement required the common unitholders' approval to increase the number of units issued and to create additional classes or series of units. The court looked to the relevant provisions of the agreement and determined that authorization was required for the issuance of units and that the proper way to increase the number of units the company was authorized to issue would be through amending the operating agreement. Neither authorization of the issuances nor approval of the amendments to increase the number of units was obtained from the common unitholders.

While there was a breach of the operating agreement, the court nevertheless concluded that there was no breach of fiduciary duty. Zimmerman argued that two unitholders had actual control of the company and benefited from the transactions, but the court found that the evidence showed that the unitholders were separate entities that did not act together and were thus not a controlling shareholder group.

The court then rejected Zimmerman's breach of duty claim against the directors. The court looked to the directors' fiduciary duties as defined in the operating agreement and observed that self-dealing was allowed, provided that the dealings were "on terms comparable to an unrelated third-party transaction, i.e., are entirely fair." The court concluded that Zimmerman failed to show that the challenged transactions were unfair.

Entire fairness. Zimmerman argued that the transactions were unfair because the majority of the board was interested when it approved them. The agreement provision dealing with transactions with the company by directors provided that such transactions are allowed if the material facts of the transaction are disclosed to disinterested directors and the transaction is approved in good faith or if the transaction is fair to the company. The court concluded that the challenged transactions were approved in good faith by informed, disinterested directors and, thus, arguably, should receive the benefit of the business judgment rule. Without a breach of fiduciary duty, the aiding and abetting claim necessarily failed.

The court then determined that the transactions were comparable to unrelated third-party transactions and "entirely fair." It was undisputed, the court said, that Adhezion needed money, and there was no third party that was willing to invest in the company on more favorable terms. Based on expert reports and testimony as to Adhezion's value, as well as other evidence, the court concluded that Zimmerman failed to show that any of the challenged transactions were unfair.

Having found a breach of the operating agreement, but no breach of fiduciary duty, the appropriate remedy, the court stated, was recovery by the plaintiff of any damages he suffered as a result of the breach. Because the court found that none of the challenged transactions were unfair to Adhezion, there were no damages. The court accordingly declined to award any damages beyond nominal damages of $1.

The case is C.A. No. 6001-VCP.

Attorneys: Evan O. Williford (The Williford Firm, LLC) for Robert Zimmerman. Richard A. Barkasy, David Smith, Stephen A. Fogdall and Benjamin D. Wanger (Schnader Harrison Segal & Lewis, LLP) for Katherine D. Crothall, Michael Gausling, Peter Molinaro, Robert Toni, Steve Bryant, Originate Adhezion A Fund, Inc., Originate Adhezion Q Fund, Inc., Originate Ventures, LLC, Liberty Ventures II, L.P., and Advisors, Inc.

Companies: Advisors, Inc.; Liberty Ventures II, L.P.; Originate Adhezion A Fund, Inc.; Originate Adhezion Q Fund, Inc.; Originate Ventures, LLC

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