The United States Court of Appeals for the Second Circuit issued an opinion on August 3 vacating in part the District Court’s dismissal of claims brought on behalf of a Bulso client for damages caused by a controlling shareholder’s mismanagement of a closely held corporation. The Court of Appeals held the plaintiff had properly stated a direct claim under Delaware law for breach of the covenant of good faith and fair dealing implicit in the parties’ shareholder agreement. The district court had dismissed Mr. Miller’s claims in their entirety, holding that they could only be brought derivatively.
Tyler Miller helped found a company that refurbished cell phones. The company was successful, and he and his cofounder sold a controlling stake to a customer, Brightstar Asia Ltd. The parties entered a shareholders’ agreement that gave Mr. Miller options both to buy back the shares he had sold and to sell the shares he had retained. And the agreement keyed the prices for each option to certain variables determined by the company’s operations. Brightstar Asia proceeded to direct the company’s operations in such a way that both sets of options became worthless.
According to the Second Circuit, Mr. Miller was entitled under Delaware law to assert that claim directly, rather than only derivatively on behalf of the company, Harvestar:
The options rights described in Paragraphs 10 and 11 are individual rights; both paragraphs provide that “the Executives shall have the right” to sell shares to or purchase shares from Brightstar Asia. App’x 146 (Paragraph 10), 148 (Paragraph 11). Those express contractual terms imply that Brightstar Asia will not engage in “arbitrary or unreasonable conduct” to destroy the value of Miller’s options rights. See Dunlap, 878 A.2d at 442.Miller alleges that sort of misconduct in his complaint. According to Miller, Brightstar Asia’s misconduct includes “plac[ing] millions of dollars in intercompany loans and other obligations on Harvestar’s balance sheet” and “cancel[ling] all repair services Harvestar was formed to provide to its customers, except the repair work that Harvestar provides to Brightstar Asia.” App’x 122-23. By operation of the formulas described in Paragraphs 10 and 11, “the price at which [Miller] has the right to ‘put’ the purchase of his shares to Brightstar Asia is currently $0” while “the price at which [Miller] has the right to ‘call’ the purchase of Brightstar Asia’s majority interest in Harvestar is … a prohibitively expensive and unreasonable amount.” Id. at 128-29. In sum, Count III alleges that “Brightstar Asia has caused plaintiff’s ‘put’ rights pursuant to Paragraph 10 of the Shareholders Agreement and plaintiff’s ‘call’ rights pursuant to Paragraph 11 of the Shareholders Agreement to be rendered worthless.” Id. at 128. That conduct, according to the complaint, violated the “implied covenant” that “required, inter alia, that Brightstar Asia refrain from engaging in, or causing Harvestar to engage in, conflict[ed] transactions to the detriment of Harvestar or plaintiff.” Id. at 127 (emphasis added). Because Miller alleges a violation of an implied contractual duty owed to himself, he may bring Count III in a direct suit.* * *An implied covenant between Brightstar Asia and Miller to avoid conduct that would unreasonably undermine the value of Miller’s options rights would not “circumvent” a bargain between Brightstar Asia and Harvestar to avoid conflicted transactions. Dunlap, 878 A.2d at 441. Thus, Paragraph 14 does not render Miller’s implied covenant claim impermissibly duplicative.
The Court of Appeals also agreed with the plaintiff on a procedural point, that the district court’s decision to apply a particular standard of review when considering whether to adopt a magistrate judge’s report and recommendation did not control the Court of Appeals’ standard of review. See id. at 8–12. The case will now return to the Southern District of New York for further proceedings.
Bulso PLC member Paul Krog briefed and argued the case before the Second Circuit.