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Litigation Trends In the Private Equity and Venture Capital Space

May 13, 2022 Podcast
Upside

In today's Upside episode, we explore fiduciary duty in the venture capital context. Can owners of a venture capital management company act in ways that explicitly disadvantage their business partners? Can they agree to waive any fiduciary duties to each other? Today, on the Upside we've got backstabbing, trickery, self-dealing, and maybe a shot at justice.

Alex Reese: Hello listeners, my name is Alex Reese. I'm a litigation partner at Farella Braun + Martel and I practice in the firm's complex litigation and IP litigation groups. I'm happy to be joined today by my colleague, Cynthia Castillo, who is a senior associate in our litigation group.  We're really looking forward to today's discussion to talk about some recent cases we've handled that focus on fiduciary duty in the context of venture capital disputes. Cynthia, this is my first time ever doing a podcast. How about you?

Cynthia Castillo: Yes, this is also my first time. Although, full disclosure, this is our second attempt at a first podcast. Let's see how this one goes.

Alex Reese: That's right. We did kind of have to bail midway through the last effort. But I like to think of that as we've done the flight simulator, and now we're ready to try flying the airplane. Let's go crash and burn.

Cynthia Castillo: Sounds good.  I'm excited to be here today to talk about litigation in the private equity and venture capital space. We've come across a lot of the same issues in the litigation matters we've separately worked on. And today, we want to talk more about one of those issues, the fiduciary duties that members of the management company owe to each other and the company.

Alex, I understand that you recently litigated this issue in one of your cases. Can you tell me what the issue was?

Alex Reese:  Yeah, I have. So this is an ongoing dispute. Or, at least as of the time of this recording, it's an ongoing dispute so, I'm going to keep it confidential and not mention names. But, at a high level, our client was one of a group of managing partners of a venture capital firm. He was a co-owner of the management company and he had sort of an interpersonal dispute with one of the co-owners. And so, what happened was a group of them, that constituted the majority of the owners, decided to get together and amend the operating agreement over our client's objection to give themselves the ability to push him out of the company. So, that's what they did. They voted to amend their operating agreement and then pretty much, the next day they voted to kick him out of the management company.

Cynthia Castillo: Wow, that sounds mean. But how do fiduciary duties play into this case, if all they did was amend the operating agreement? Isn't it okay if they have the power to do that?

Alex Reese: Yeah, it's a great question. Let me just tell a little bit of the story because it's actually quite a saga and it has some juicy facts, and I wish I could share all of them, but I'll share some of the fun ones, at least.

As I mentioned, there was a group of managing partners of this venture capital firm and the management company was a California LLC. A lot of venture capital entities are incorporated in Delaware, but this one is from California. And this group of co-owners, they ran the company really like a partnership. They referred to each other as partners, and ran the company sort of on a consensus model for many years. They worked together for about 20 years and actually their operating agreement at the time we filed this dispute in JAMS arbitration was more than 15 years old. They hadn't updated it since the early 2000s.

Cynthia Castillo: Whoa. That's a practice pointer right there. You want to keep your company agreements updated more frequently than that. Almost any company will change a lot during 15 or 20 years and over the course of its business. It's important to have your company documents keep pace with your business and changing times.

Alex Reese: Yeah, I completely agree. And that's a general observation that I think is correct and it's definitely true of this company. Over the 20-year history of the company, it had grown leaps and bounds, and had billions of dollars in assets under management, where they had started much smaller than that. And their governing documents had not kept pace with the changes in the company.

Most importantly, for the purposes of our lawsuit, the original operating agreement that they had been using for years and years, it had no provision for getting rid of a co-owner—what's called a member in an LLC. This group of co-owners referred to each other as partners, and there was no provision in the operating agreement for what do you want to do if you want to get rid of one of your partners.

There was no power to vote someone off the island. There was no power to take someone's interest in the company away. And they were all kind of locked together in perpetuity under this operating agreement. There were provisions that would allow a partner to voluntarily leave. But even in those circumstances, there was no provision that said what a departing partner should be paid. So, this was an agreement that was very old, and was sort of ripe for problems if there were disputes between the co-owners.

And a couple years ago, these simmering tensions that had been growing between some of the co-owners really boiled over, and there was a big interpersonal beef. Two of the partners, in particular, had really strong disagreements with each other. And, without getting too far into the details, basically, the situation between the group of co-owners became untenable. They couldn't work together anymore. And so, our view from our client's perspective is the right thing to do in that situation under the operating agreement would've been, "Okay, we can't work together anymore. Let's sit down and be grownups and talk about this like adults. You want me to leave the company? Let's talk about how much it will cost to buy my interest out." Instead, what they did was a group of the co-owners that constituted a majority kind of got together in secret without telling our client that they were doing this, and agreed that they would amend the operating agreement.

Now, the operating agreement did have a provision saying that a majority of the co-owners could amend it. And so, that's what they did. They relied on that power, and they voted to amend the operating agreement to give themselves a completely new power, the power to kick someone else out of the company. And they didn't stop there. They actually agreed that when they exercised this new power to kick someone out, they also would give them a very small fraction of what the ownership was worth. And they actually had a formula added into the operating agreement that had never been there before saying, this is exactly what you'll get if we kick you out. And by the way, it's pennies on the dollar.

Cynthia Castillo: Wow. Pretty dramatic stuff.

Alex Reese: Yeah, it really was.

Cynthia Castillo:  Was there actually a formal vote on these new amendments and was it actually done in secret without the minority members?

Alex Reese: That's a good question. The vote, if you could really call it that, did take place with participation of the minority members. But it took place entirely by email. There was an email sent around to all of the co-owners saying, "Hey, here are the new red-lined amendments to the operating agreement. Everybody say yay or nay by email." But what our client didn't know, until we filed the lawsuit, was that for about a month before that email was sent around, the majority group of co-owners had been exchanging drafts and talking about the substance of the amendments in secret without telling our client and another minority member that they kicked out at the same time.

Cynthia Castillo: Wow. So, again, this really sounds mean-spirited conduct. But how does fiduciary duty play into this?

Alex Reese: It's a great question. And I know you worked on a case dealing with fiduciary duties in the venture capital context where it was a Delaware corporation, or Delaware LLC. And we'll talk about that in a minute.

In our case, the management company was formed in California as an LLC formed under the California Corporations Code. And in California, and I think this is true in Delaware as well, fiduciary duties are set forth in the statute right there in the LLC Act, the revised Uniform LLC Act in the California Corporations Code. They say who owes fiduciary duties to whom in an LLC and it can vary depending on how your LLC is operated. But following up on that statutory fiduciary duty, there is a line of cases saying, essentially, that you can't exercise your powers as a co-owner of an LLC in a way that specifically disadvantages other LLC members.

And there's one case, it's called Farisi vs. Delivery case. It's a California appellate court case, where there was one person who was the sole manager of a California LLC and then, there was a handful of members. And the statute says that, in that context, the manager owes fiduciary duties to all the members. And it's sort of a convoluted story but, in that case, the manager, he took advantage of one of the other members in a financial way by refusing to disclose information to her in a transaction that was actually unrelated to the LLC's business. It was outside the context of the LLC. But even there, the court said, "No, the manager owed the highest duty to all the members of the LLC and could not take advantage of them in any way," and found that his actions breached his fiduciary duties.

And so, that's a line of cases. That's one case, and there's a line like that we're relying on to say, in the LLC context, if you are a manager, not just a passive investor in the LLC, you owe all the other members the highest duty of loyalty and you can't do something to take advantage of them in any way.

Cynthia Castillo: That's really interesting. But it seems like it could be a hard line to draw. LLC members probably do have the ability to vote in a way that advances their own interests in the LLC, right? If there's a potential deal on the table, and one member thinks it will be great for him, and another doesn't, certainly, they're allowed to vote their self-interest as long as they're not intentionally harming the company, right?

Alex Reese: Yeah, it's a really interesting question. And it's one we've discussed at some length in recent months because of this case that we have. And I think you're right, it's a hard line to draw. When are you voting your self-interest versus when are you voting specifically to harm, or to disadvantage one of the other members? And what makes this case so interesting and challenging is where do you draw that line?

In our case, we think we have the better end of the argument, and it's still to be determined because the case is ongoing. But we think we have the better end of the argument because of the factual scenario, the story that led up to the vote on the amendments. It wasn't as if one day they all had an open discussion about amending their operating agreement, and some agreed, and some disagreed, and everybody voted how they wanted to vote.

Instead, a group, the group of majority owners got together behind the other co-owners' backs, and all agreed among themselves what the amendments were going to be without telling them. And they knew that these amendments were specifically targeting the two minority owners of the company. When they voted, it wasn't so much that they were voting their self-interest, they weren't voting because, "Oh, we think these amendments are for the company. They're just sort of housekeeping amendments, or they're going to make us run more efficiently, or for the good of the order to pass these amendments."

Instead, they voted specifically so that they could then kick out two of their other co-owners. And that's exactly what they did. They passed these amendments and then, within a couple of days, they held another vote getting rid of the two minority members of the ownership team, including our client.

And so, I agree with you, it's a really hard line to draw. We think here, the facts are going to bear out that this was an instance where people were voting not just in their own self-interest, and not just to promote the company's interest where there's an honest disagreement about what that might be. But instead, they were voting to give themselves the power specifically so that they could then exercise the power to the great disadvantage of some of the other co-owners of the company.

Anyway, that's enough about my case. It's a fascinating one and I could talk your ear off about it all day. But I know you have had a similar case or a case, at least in the venture capital context, where fiduciary duties were an issue. Can you tell us a little bit about that case?

Cynthia Castillo: Yeah, it was similar in that there is a dispute between managers or members of a private equity firm. This firm had been founded by two members and, after a falling out, one member bought out most of the other members' share. But that member who was effectively leaving the company retained a small share of the company, but he was no longer managing. So, there's now a sole manager of the LLC.

Several years pass and this minority interest holder, this non-managing member, comes to find out that the managing partner of the LLC had been running the company in a way that was solely to line his own pocket. He's really just making decisions that benefit him to the exclusion of the other member. And the facts are egregious, and I can't get into them, but what this was, was an allegation of self-dealing by the manager of this company. It gets very complicated. And then the manager goes to prison, but for unrelated conduct. But that sort of gives you a flavor of what was going on here.

Alex Reese: I thought my case was juicy. We don't have anybody behind bars in my case.

Cynthia Castillo: Yes. It was really, really interesting factually. But there was an arbitration related to breach of fiduciary duties. One of the key differences, however, was that this company was formed in Delaware, and the operating agreement for the company waived all fiduciary duties that the members owed to each other, or that they owed to the company. And that made the case much more difficult, much more of an uphill battle. You really have to show very egregious conduct. And even when egregious conduct does exist, it's still a difficult case.

Alex Reese: Yeah, that's interesting. I know Delaware has this provision, I think California does as well to some extent, that you can waive fiduciary duties in your LLC operating agreement. And one thing since our case is in California, not in Delaware, but I've wondered about the ability in Delaware to waive fiduciary duties is sort of how far does that go? Can you waive fiduciary duties in your operating agreement, and then go on to take actions that actually harm the LLC? Or is there some kind of limit? Even once you've waived fiduciary duties, is there some kind of limit to what you can do? Do you know the answer to that?

Cynthia Castillo: In Delaware, you're right, with a Delaware LLC you can waive fiduciary duties between members and to the company. But there is still an implied covenant of good faith and fair dealing. And this is, essentially, a contract term. It's implied in every contract. It can't be waived. But it's very narrow, and so it's really possibly only going to apply in some narrow, grossly egregious circumstances.

There was a recent case in 2018 Miller vs. HCP & Co. where the Chancery Court in Delaware said, if you sign an operating agreement and you waive fiduciary duties, that means you're waving fiduciary duties. And the court is not going to come in and rescue you from that agreement when a party doing something allowed by the operating agreement treats someone else unfairly.

I think it remains to be seen how far these waivers can be taken. Certainly, if there's gross misconduct and you can't make a textual argument that conduct was permitted by the agreement, then it's possible that the implied covenant of good faith and fair dealing will come and save the day. But I think the lesson here is that parties aren't going to be bailed out when the operating agreement allows the managers, or the members, to engage in conduct that might, in other circumstances, breach fiduciary duties.

Alex Reese: It's so interesting that it seems like the Delaware courts are saying through this Miller case that you mentioned, that once you wave fiduciary duties, all bets are off. You can run the LLC like your own personal fiefdom. You can use company money to pay your personal expenses. You can kind of do whatever you want. And since it's all governed by contract, the LLC operating agreement, if you sign up for an LLC like that, where fiduciary duties were waived, you've been warned. You had the opportunity to look at the operating agreement, and you should know what you're getting into if you see a waiver of fiduciary duty. Then you're going in with your eyes wide open. I guess it seems like that's kind of the court's viewpoint there.

Cynthia Castillo: I think that's very possibly right. I mean, like I said, it remains to be seen how far this can be taken in terms of self-dealing and that type of conduct, but it's right you need to walk into these situations with your eyes wide open, particularly, if there's a waiver of fiduciary duties.

Alex Reese: Yeah. All right, it was really fun hearing about your case. And thank you for letting me bore you for a few minutes about mine. It's always fun to share war stories.

And hearing you talk about your lawsuit just made me realize one of the reasons that I have really enjoyed working as a litigator in the venture capital space is because the clients are just great to work with. They're sophisticated, they're smart. And the other thing is you really get to know the clients on a personal level. We're dealing with the principles, the people that are running the company and making the decisions. And often, even a large venture capital company with a lot of money under management is still run by a relatively small group of people. You really get to know the clients on a personal level, which is just very gratifying as an attorney to really get to know your client that well.

Cynthia Castillo: Another reason why practicing in the venture capital world is interesting is the issues are complex. There are a lot of complicated legal issues that come into play. Today, we discussed the obligations among the owners of the management company, and the managers of various fund entities. In future podcasts. We're going to discuss some other issues we've come across in our practices, including how firms protect sensitive information, such as client lists, issues related to navigating interrelated but distinct legal entities, and issues related to venture capital private equity relationships with officers and employees. We hope you stay tuned for those future episodes.

Alex Reese: Nice teaser, Cynthia. All right, we got good stuff on deck here.

Well, that's all for today. I'm Alex Reese. And I was talking here with my colleague, Cynthia Castillo. Thanks so much Cynthia. And listener, you've been listening to Upside by the private equity and venture capital team here at Farella Braun + Martel.

Find more episodes of Upside here or wherever you listen to podcasts.

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