As previously reported, in NAF Holdings, LLC v. Li & Fung (Trading) Limited, 772 F.3d 740 (2d Cir. 2014), the Second Circuit certified to the Delaware Supreme Court an unusual question regarding whether the direct vs. derivative test for stockholder claims would bar a direct breach of contract claim by a parent corporation whose subsidiary was injured. The Delaware Supreme Court has now given its answer: the direct vs. derivative analysis for fiduciary breach claims does not apply and the parent company may sue directly to enforce its own contracts, regardless of its status as stockholder of an injured subsidiary.
The issue arose following a failed acquisition transaction. The proposed acquirer, NAF, contracted directly with defendant Li & Fung to provide services to the target company. NAF then formed two wholly-owned subsidiaries to effectuate the acquisition. Li & Fung allegedly repudiated its agreement, causing NAF to lose the financing it needed to fund the acquisition, which resulted in injury to the subsidiaries. Li & Fung argued that, under the test established in Tooley v. Donaldson, Lufkin & Jenrette, Inc., 845 A.2d 1031, 1036 (Del. 2004), NAF’s contract claim could only be brought derivatively because NAF was a stockholder of the injured subsidiaries. In Tooley, addressing a typical minority stockholder claim of breach of fiduciary duty, the Delaware Supreme Court instructed that determining whether a stockholder’s claim is derivative or direct turns on “[w]ho suffered the alleged harm – the corporation or the suing stockholders individually – and who would receive the benefit of the recovery or other remedy?” 845 A.2d at 1035. To maintain a direct claim, “[t]he stockholder’s claimed direct injury must be independent of any alleged injury to the corporation. The stockholder must demonstrate that the duty breached was owed to the stockholder and that he or she can prevail without showing an injury to the corporation.” Id. at 1039.
The District Court accepted Li & Fung’s argument and dismissed NAF’s direct claim for breach of contract. However, the Second Circuit was more skeptical about the applicability of the Tooley standard for fiduciary breach claims to a commercial contract claim. Finding no apposite law, the Second Circuit certified to the Delaware Supreme Court the question, “may the promisee-plaintiff bring a direct suit against the promisor for damages suffered by the plaintiff resulting from the promisor’s breach,” or, because the plaintiff owns stock in the injured corporation, may the plaintiff “enforce the contract only through a derivative action brought in the name of the third-party beneficiary corporation?” 772 F.3d at 750.
The Delaware Supreme Court has now answered the certified question: “a promisee-plaintiff [may] bring a direct suit against the promisor for damages suffered by the plaintiff resulting from the promisor’s breach, notwithstanding that (i) the third-party beneficiary of the contract is a corporation in which the promisee-plaintiff owns stock; and (ii) the promisee-plaintiff‘s loss derives indirectly from the loss suffered by the third-party beneficiary corporation.” NAF Holdings, LLC v. Li & Fung (Trading) Limited, 2015 WL 3896792, *1 (June 24, 2010). That is, “a party to a commercial contract may sue to enforce its contractual rights directly, without proceeding by way of a derivative action.” Id. at *3.
The Delaware Court explained that “Tooley and its progeny do not, and were never intended to, subject commercial contract actions to a derivative suit requirement.” The Tooley analysis was intended only to draw the line between direct stockholder suits for breach of fiduciary duty and derivative stockholder suits for breach of fiduciary duty, which are subject to demand excusal rules. Id. at *3. In contract cases, a “more important initial question” is whether the proposed claim belongs to the stockholder personally or to the corporation. Thus, while “it is of course true that NAF cannot bring direct contractual claims belonging only to its subsidiaries without first proving demand futility,” that “does not mean that NAF must proceed derivatively as to contract claims NAF itself possesses.” The Tooley language “was applied by the U.S. District Court … in a decontextualized manner that is inconsistent with Delaware law, which seeks to ensure freedom of contract and allow parties to enforce their bargains in our courts.” Id. at *4.
The Delaware Court recognized that the disputed issues regarding injury and available remedies “might affect the viability of NAF’s breach of contract claim and its ability to prove compensable damages. But those issues relate to the merits of NAF’s contract claim, and have no bearing on whether the claim itself is derivative in nature.” “Therefore, we simply answer the question posed by our learned friends by holding that a suit by a party to a commercial contract to enforce its own contractual rights is not a derivative action under Delaware law.” Id. at *5.
This general holding of the Delaware Supreme Court is a welcome assurance for corporate transacting parties that, if the deal goes bad, at least the parent corporation will not be subjected to a burdensome demand excusal process when it sues to enforce its own contract.