“Does the diminution in the value of a limited liability company, which serves as a feeder fund in a limited partnership, provide a basis for an investor’s direct suit against the general partners when the company and the partnership allocate losses to investors’ individual capital accounts and do not issue transferrable shares and losses are shared by investors in proportion to their investments?”
The question before the Court boiled down to whether the claims brought by Culverhouse were direct or derivative. Confusion surrounding the issue arose from the 11th Circuit’s attempt to rectify the Delaware Supreme Court’s prior holding in Tooley v. Donaldson, Lufkin & Jenrette and the Court of Chancery’s holding in Anglo American Security Fund, L.P. v. S.R. Global International Fund, L.P.
The Supreme Court in Tooley established a two-part test to determine if a claim is direct or derivative. For a claim to be direct, the plaintiff must show: (1) that he or she suffered a harm individually (not a harm to the corporation); and (2) recovery or any other form of relief can be had by the individual.
In Anglo, which preceded Tooley by six months, the plaintiffs were limited partners in an investment fund and the defendants were the general partner and the fund’s auditor. The limited partners sought to bring direct claims against the general partner arising from the general partner’s allegedly improper withdrawal of over $22,000,000 from the fund. The Court of Chancery denied the general partner’s motion to dismiss and found that the former limited partners stated direct diminution of value claims. The Chancellor concluded that:
Due to the structure and operation of the Fund, whenever the value of the Fund is reduced, the injury accrues irrevocably and almost immediately to the current partners but will not harm those who later become partners. Although other types of injuries could harm the Fund as an entity in ways that appropriately could be challenged in a derivative action, injuries that result in a direct reduction of the Fund’s assets will effect an almost immediate reduction in the capital accounts of each of the existing partners. Such losses confer only a fleeting injury to the Fund, one that is immediately and irrevocably passed through to the partners.
Characterizing the plaintiffs’ claims as derivative would thus have the perverse effect of denying standing (and therefore recovery) to parties who were actually injured by the challenged transactions while granting ultimate recovery (and therefore a windfall) to parties who were not. This result is antithetical to the first purpose of derivative litigation identified in Cencom, does nothing to further the gatekeeping functions of derivative litigation requirements, and, in the words of Vice Chancellor Steele, “makes no sense.” I hold that the plaintiffs’ claims related to Sloane’s February 18, 2000, withdrawal are direct claims.
The 11th Circuit found Anglo informative for the case at bar due to the similarities in the structure of the funds.
The Delaware Supreme Court, however, distinguished Anglo from the case at bar based on the nature of the investment. In Anglo, the investors did not use a feeder fund, they had a direct relationship with the investment fund and its manager. In contrast, Culverhouse only had a legal relationship with the feeder fund, not the investment fund.
The purpose of a feeder fund is to allow investors who do not meet the requirements of the investment fund to aggregate their investments and invest in the investment fund. Each fund has its own agreements, and for the court to undermine these agreements would place a veil of uncertainty over the corporate world. Because of the nature of business in Delaware, “Delaware courts take corporate form and corporate formalities very seriously.”
Here, the investment fund managers owed fiduciary duties to the investors who invested directly in the investment fund. Culverhouse chose to invest directly in the feeder fund, which in turn invested in the investment fund; Culverhouse did not invest directly in the investment fund. The alleged harm stemming from the investment fund losses at issue would not be suffered by Culverhouse in the first instance, nor would Culverhouse receive the benefit of any recovery in the first instance. Therefore, Culverhouse’s claims fail under both prongs of the Tooley test, and Culverhouse’s claims are derivative.
The full opinion can be read here.