Was it your long-time confidant who says your fiancee isn’t good enough for you and then runs off and marries her, or a seller’s remorse on a hundred-million dollar scale? We don’t know yet, but in Allen v. Devon Energy Holdings, a Houston court set guidelines for the trial of a case involving redemption of a member’s ownership interest in a limited liability company for a fraction of the amount he would have received in the sale of the entire company 20 months later.
This was an appeal of a summary judgment, not a trial, so no actual wrongdoing by anyone was established.
The facts are complicated and the legal analysis is detailed, which makes this post longer than usual. For lawyers, it is a quick treatise on the ins and outs of fraud claims and a warning that the “boilerplate” in your agreements might not be as effective as you think. For non-lawyers, it is about legal issues that could affect behavior among members of LLCs and shareholders of corporations, whether majority or minority owners.
Having tried in vain to avoid the turgid legalese non-lawyers have come to expect from people like me, I’ve inserted musical interludes about cheatin’ and betrayal that should help alleviate the stupefying boredom you are about to experience. For example:
Allen and Rees-Jones had been law partners and, said Allen, “long-time friends”. Allen redeemed his member interest in Chief for $8 million. For that interest he had invested $600 in cash and a $36,000 letter of credit 10 years earlier. Prior to the redemption transaction Rees-Jones, who controlled the company, gave appraisals and valuations and made certain statements that induced Allen to sell his interest. Rees-Jones made pessimistic predictions about future prospects based on two represented facts: lack of success in drilling in an area in which Chief would expand and absence of certain drilling technology essential to profitable production. Two years later, the company was sold in a transaction that would have netted Allen 20 times his redemption price.
On the one hand you had a sophisticated lawyer who represented parties in similar oil and gas transactions and on the other hand you had a nonoil and gas person (the lawyer) who relied heavily on the expertise and statements of the seller (Rees-Jones).
Allen alleged that in the eight months between the representations and the redemption, two represented facts changed and Rees-Jones did not disclose them; these were material changes that rendered his earlier representations untrue and misleading.
Allen asserted claims for all sorts of corporate treachery, including fraudulent inducement, violation of the Texas Securities Act, statutory and common law fraud, fraudulent concealment, breach of fiduciary duty, and shareholder oppression.
Chief responded that the redemption agreement’s general-merger, “independent investigation” and mutual-release clauses barred all of the claims.
RULES OF LAW ESTABLISHED
The Release Clause
• A contractual release in a closing document may be avoided by proof that it was fraudulently induced.
• A contract may preclude a valid fraudulent inducement claim if it clearly expresses the party’s intent to waive those claims, or disclaims reliance on representations about specific matters in dispute. (pg 9). But a general release does not express an intention to waive fraudulent inducement claims. (pg 9).
Actionable and Non Actionable Statements
• Generally, but not always, opinions are not actionable. (pg 12). This includes claims for fraud by nondisclosure. (pg 14). An example of an opinion that is actionable is a mixed statement of fact and opinion. (pg 13). A statement of opinion interrelated with factual statements about drilling technology and the effect on profitability could be actionable. (pg 20-21).
o A statement of opinion can be actionable when (1) the speaker knows the expressed opinion is false (2) the speaker has superior knowledge and should have know the other party was justifiably relying on that knowledge (3) the opinion is so intertwined with misstatements of fact that the whole statement amounts to a false representation of fact. (pg 12-13).
• A representation that Rees-Jones intended to work less in the future could be actionable if it wasn’t true. (pg 21).
o A statement promising future performance (i.e. a statement of intent) may be actionable in fraud if the speaker did not have the intention of performing when the statement was made. (pg 13, 21).
o Predictions and promises to perform are typically non-actionable in fraud, but a prediction is actionable if the speaker claims or purports to have special knowledge of acts that will exist or occur in the future. (pg 13) .
• A representation that Rees-Jones did not expect the company to continue to grow “at this pace” was not actionable because it was a prediction about the future profitability or value of the business.
o A prediction relating to the future profitability or value of a business is a quintessential non-actionable opinion. (pg 21-22).
o But a prediction may be actionable when it is based on or buttressed with a factual representation or false facts (or specifically tied to statements of fact). (pg 19, 37). Here Rees-Jones opinion regarding the creation of new value was not actionable because it was not directly tied to any allegedly fraudulent statements of existing fact, was not a statement of intent, and did not promise any future performance. (pg 23).
• A non-actionable statement cannot create a duty to speak. (pg 24).
Contractual Disclaimer of Reliance – The “Independent Investigation” Clause
• Reliance is generally a necessary element of a fraud claim, but parties can disclaim reliance in a contract. (pg 26). The disclaimer must be clear and unequivocal. (pg 28).
• An “independent investigation” clause generally says that a party had the opportunity to obtain additional information and to obtain answers from his own advisors. Such a clause must “contain the kind of absolute and all-encompassing language that satisfies the clarity requirement as to any fraudulent inducement claim.”
• Saying that the seller’s decision to sell is based on his own investigation does not clearly and unequivocally negate the possibility that his decision was also based on fraudulent information. The clause should have said the seller relied “solely” on his investigation or “exclusively” or “only”. (pg 32-33).
The Integration Clause
• A “finality”, also called a “pure merger” or integration clause, must be sufficiently clear to disclaim reliance or waive claims for fraudulent inducement. (pg 30-31).
o Here, the merger clause made no reference to reliance or fraudulent inducement and only amounted to an expression of intent to merge prior negotiations into the final written agreement. (pg 30-31).
• Statements of value, while ordinarily not actionable, can be actionable if they are buttressed by or intertwined with factual representations. (pg 37).
• When looking at the totality of the circumstances test, proving that the parties are sophisticated and representing by counsel is not sufficient to support the enforcement of the disclaimer. (pg 43).
• Justifiable reliance is element of b oth common law fraud and fraudulent inducement. (pg 46).
o The justifiable reliance issue is generally a question of fact. (pg 48). The issue becomes a question of law when undisputed facts show circumstances under which reliance cannot be justified. For example, a party cannot justifiably rely on a representation when the party has actual knowledge of the representation’s falsity at the time of the alleged reliance. (pg 48).
o A party may not justifiably rely on a statement that is directly contradictory to the express terms of the written agreement. (pg 48).
• The Houston court has held that the majority shareholder bears a fiduciary duty in certain circumstances but not in others. (Pg 55).
• Generally, courts in Texas decline to recognize a formal fiduciary duty by a majority shareholder to a minority shareholder in a closely held corporation while recognizing that an informal fiduciary duty could exist depending on the circumstances. (Pg 56). Rees-Jones had intimate knowledge of Chief’s daily affairs and plans and he was in charge of day-to-day operations. Allen was a passive investor and seldom received status reports and Rees-Jones was his sole source of information on Chief’s status over the years. This relationship is like one of a general partner to a limited partnership. (pg 60).
• In the purchase of a minority owner’s interest in an LLC, a majority owner’s fiduciary duty requires disclosure of those matters which the officer has knowledge and about which the shareholder has a right to know so that the latter may have the benefit of the information in judging the advantages of the deal. (pg 61-63).
• Information is material to a transaction if there is substantial likelihood that under all circumstances the omitted fact would have seen greater significance in the deliberation of the reasonable shareholder and would have been viewed by the reasonable investor as having significantly altered the mix of information available. (pg 62).
• The special facts are acute when the majority owner and member manager who controls the company’s daily affairs and possesses inside information communicates a redemption offer that will increase his ownership of the company to minority members who do not participate in the company’s daily affairs. (pg 64).
• There is a formal fiduciary duty when (1) the alleged fiduciary has a legal right of control and exercises that control by virtue of his status as the majority owner and sole member-manager of a closely-held LLC and (2) either purchases a minority shareholder’s interest or causes the LLC to do so through a redemption when the result of the redemption is an increased ownership interest for the majority owner and sole manager. (pg 65).
• An LLC may eliminate liability for governing persons such as officers and directors to the members of the LLC. (pg 67).
• Here, the majority owner’s duty of loyalty to the LLC ran to the LLC’s members individually, as well as collectively. (pg 69).
• Shareholder oppression is: (1) majority shareholders’ conduct that substantially defeats the minority’s expectations that, objectively viewed, were both reasonable under the circumstances and central to the minority shareholder’s decision to join the venture; or (2) burdensome, harsh, or wrongful conduct; a lack of probity and fair dealing in the company’s affairs to the prejudice of some members; or a visible departure from the standards of fair dealing and a violation of fair play on which each shareholder is entitled to rely. (pg 72-73).
• Shareholder oppression does not include claims for “wrongful conduct” of fraud by misrepresentation and breach of fiduciary duty. (pg 74).
Texas Securities Act
• A defendant-buyer under the TSA is not liable if it shows that the seller knew of the untruth or omission. (pg 75).
• Similar to the fraud claims, the court concluded that Allen’s knowledge about the change in Chiefs value has the same effect on Allen’s TSA claims as it had on Allen’s other fraud claims under the “justifiable reliance” requirement: it does not bar Allen’s TSA claims except to the extent Allen alleges that Rees-Jones’s representations communicated information about the suitability of the redemption price and the value of Chief and its assets at the time of the redemption. (75-76).
• The Court gave the limitations statute its plain meaning and held that subsection (a)’s five-year repose period runs from the date of the redemption and subsection (b)’s three-year limitations period runs from the date Allen discovered or should have discovered the alleged “untruth[s] or omission[s],” without reference to the timing of injury or damages. (pg 77).
• The availability of information through various mediums, including the Railroad Commission website, a Morgan Stanley Report, a Goldman Sachs report, or the drillinginfo.com, was not enough to satisfy Chief’s burden of proof on limitations because Chief failed to identify or cite any specific information that would have revealed to Allen any of the alleged untruths or omissions (pg 82-86).