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Naf Holdings, LLC v. LI & Fung (Trading) Ltd.

Supreme Court of Delaware

June 24, 2015

NAF HOLDINGS, LLC, Plaintiff/Counter-Defendant, Appellant,
v.
LI & FUNG (TRADING) LIMITED, Defendant/Counter-Claimant, Appellee

Submitted: June 17, 2015.

Case Closed July 10, 2015.

Certification of Question of Law from the United States Court of Appeals for the Second Circuit in Docket No. 13-830-cv.

Michael F. Bonkowski, Esquire, Cole, Schotz, Meisel, Forman & Leonard, P.A., Wilmington, Delaware; Bruce H. Nagel, Esquire (argued), Robert H. Solomon, Esquire, Andrew Pepper, Esquire, Nagel Rice, LLP, Roseland, New Jersey, for Appellant.

Richard D. Heins, Esquire, Peter H. Kyle, Esquire, Ashby & Geddes, Wilmington, Delaware; John J. Hay, Esquire (argued), Ulyana Bardyn, Esquire, Dentons U.S. LLP, New York, New York, for Appellee.

Before STRINE, Chief Justice; HOLLAND, VALIHURA, VAUGHN, and SEITZ, Justices, constituting the Court en banc.

OPINION

Page 176

STRINE, Chief Justice.

I. INTRODUCTION

The U.S. Court of Appeals for the Second Circuit has certified the following question of law arising out of an appeal from a decision issued by the U.S. District Court for the Southern District of New York:

Where the plaintiff has secured a contractual commitment of its contracting counterparty, the defendant, to render a benefit to a third party, and the counterparty breaches that commitment, may the promisee-plaintiff 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 plaintiff-promisee owns stock; and (ii) the plaintiff-promisee's loss derives indirectly from the loss suffered by the third-party beneficiary corporation; or must the court grant the motion of the promisor-defendant to dismiss the suit on the theory that the plaintiff may enforce the contract only through a derivative action brought in the name of the third-party beneficiary corporation?[1]

For reasons we explain more fully, the answer under Delaware law is, " 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." In other words, a party to a commercial contract who sues to enforce its contractual rights can bring a direct contract action under Delaware law. Although the relationship of that party to the third-party beneficiary might well have relevance in determining whether the contract claim is viable as a matter of contract law, nothing in Delaware law requires the promisee-plaintiff's contract claim to be prosecuted as a derivative action.

The case law under Tooley v. Donaldson, Lufkin & Jenrette [2] and its progeny deal with the distinct question of when a cause of action for breach of fiduciary duty or to enforce rights belonging to the corporation itself must be asserted derivatively. That body of law has no bearing on whether a party with its own rights as a signatory to a commercial contract may sue directly to enforce those rights.

Page 177

II. THE EVENTS LEADING TO THE CERTIFIED QUESTION[3]

NAF Holdings, LLC (" NAF" ), a Delaware limited liability holding company wholly owned by Efrem Gerszberg, sought to acquire Hampshire Group, Limited (" Hampshire" ), a public company that produces and markets fashion apparel. NAF contracted with Li & Fung (Trading) Limited (" Li & Fung" ), a Hong Kong Company, to serve as the sourcing agent for Hampshire, which was an essential condition for the third-party financing commitments NAF needed to complete the acquisition. After contracting with Li & Fung, NAF created two wholly-owned subsidiaries (the " NAF Subsidiaries" ) to effectuate the acquisition. The NAF Subsidiaries entered into a merger agreement with Hampshire, which was to take effect when the Subsidiaries purchased Hampshire's stock in a tender offer. NAF was not a party to the merger agreement.

According to NAF, Li & Fung then repudiated its contract with NAF and refused to serve as Hampshire's sourcing agent, causing NAF to lose its financing commitments. NAF claims that because of Li & Fung's breach, it was unable to fund the NAF Subsidiaries' acquisition of Hampshire, which allegedly resulted in a $30 million loss.

After the NAF Subsidiaries and Hampshire terminated their merger agreement, Gerszberg drafted a complaint against Hampshire, alleging a variety of claims. The Subsidiaries and Hampshire eventually entered into a settlement agreement in which the Subsidiaries released all claims against Hampshire. The Subsidiaries also agreed not to initiate or support any action " against any person, whether or not a party to [the] settlement agreement" for any " losses sustained as a result of the transaction agreements or the transaction." [4] Gerszberg was a signatory to that agreement individually, but NAF and Li & Fung were not.

NAF then sued Li & Fung in the U.S. District Court of the Southern District of New York, seeking damages based on the harm Li & Fung allegedly caused when it breached its contract with NAF. The complaint sought $30 million in damages for the reduced value of NAF's property, that is, the diminution in value of the NAF Subsidiaries' stock.

Li & Fung moved for summary judgment on the ground that NAF could only bring its claim as a derivative action on behalf of the NAF Subsidiaries. The District Court granted Li & Fung's motion, concluding that because NAF was injured in its capacity as 100% owner of the NAF Subsidiaries, which had directly incurred the losses, NAF's contract claim against Li & Fung could not be maintained as a direct suit.[5] In so holding, it relied on this Court's decision in Tooley v. Donaldson, Lufkin & Jenrette, which stated that when determining whether a claim is direct or derivative,

[a] court should look to the nature of the wrong and to whom the relief should go. The 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

Page 178

he or she can prevail without showing an injury to the corporation.[6]

Because NAF had not attempted to meet the pleading requirements of a derivative suit, and even if it had, any suit on behalf of the NAF Subsidiaries would be barred by the settlement agreement with Hampshire in which the Subsidiaries relinquished their right to pursue any claims related to the transaction, the U.S. District Court of the Southern District of New York dismissed the suit.[7]

NAF then appealed to the U.S. Court of Appeals for the Second Circuit, arguing that Tooley, which involved a claim that the directors of a corporation breached their fiduciary duties, did not apply to its commercial contractual claim. We emphasize " its" for a reason: if, by way of example, a stockholder of Acme Corporation brought an action claiming that Acme's board of directors was wrongly failing to prosecute a claim for a breach of a contract that Acme had signed because an insider was the breaching party, that suit would need to be brought derivatively on behalf of Acme. But that is because the stockholder was seeking to enforce Acme's contractual rights on the corporation's behalf, not her own individual rights.[8]

NAF also argued that requiring shareholders with commercial contract claims to sue their counterparty derivatively because the injury arose out of harm to a subsidiary would conflict with established principles of contract law, discourage stockholders from contracting on behalf of the corporation, and undermine the purposes of derivative suits. Li & Fung contended in response that the District Court correctly concluded that NAF could not bring a direct claim because NAF only sought compensation for the harm suffered by the NAF Subsidiaries. It argued that because NAF did not suffer a direct injury independent of the harm suffered by its subsidiaries, NAF's breach of contract claim had to be brought derivatively under the principles articulated in Tooley.

Page 179

The Second Circuit expressed skepticism that Tooley would bar NAF's commercial contract claim,[9] but sought guidance from this Court on the proper analysis.

III. ANSWER TO THE CERTIFIED QUESTION

The answer to the complicated question certified to us by the U.S. Court of Appeals for the Second Circuit is that a party to a commercial contract may sue to enforce its contractual rights directly, without proceeding by way of a derivative action. Tooley and its progeny do not, and were never intended to, subject commercial contract actions to a derivative suit requirement.[10] That body of case law was intended to deal with a different subject: determining the line between direct actions for breach of fiduciary duty suits by stockholders and derivative actions for breach of fiduciary duty suits subject to the demand excusal rules set forth in § 327 of the Delaware General Corporation Law, Court of Chancery Rule 23.1, and related case law.[11]

Page 180

In concluding that NAF could proceed only by a derivative suit, the District Court focused on this Court's statement in Tooley that a stockholder-plaintiff is required to show that it " can prevail without showing an injury to the corporation" to bring a direct claim.[12] Li & Fung read this language as intended to be a general statement requiring all claims, whether based on a tort, contract, or statutory cause of action ( e.g., antitrust), to be brought derivatively whenever the corporation of which the plaintiff is a stockholder suffered the alleged harm. If that was true, NAF's suit for compensation for the diminution in value of its stock in the NAF Subsidiaries could not be brought as a direct action. But in that situation, a more important initial question has to be answered: does the plaintiff seek to bring a claim belonging to her personally or one belonging to the corporation itself? Thus, it is of course true that NAF cannot bring direct contractual claims belonging only to its subsidiaries without first proving demand futility. But that does not mean that NAF must proceed derivatively as to contract claims NAF itself possesses. Reading Tooley to convert direct claims belonging to a plaintiff into something belonging to another party would, we confess, be alien to our understanding of what was at stake in that case, or in the cases after Tooley that relied on it.[13]

The bare language cited above, in other words, was applied by the U.S. District Court for the Southern District of New York 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.[14] It is a fundamental principle

Page 181

of contract law that the parties to a contract are bound by its terms, and have a corresponding right to enforce them.[15] In addition, our law seeks to promote reliable and efficient corporate laws in order to facilitate commerce.[16] It would be inconsistent with these legal principles to subject commercial parties to a burdensome demand excusal process before allowing them to sue on their own commercial contracts.[17]

We clarify that allowing NAF to press its breach of contract action directly does not in any way signal our view of the merits of that claim. Nor do we evaluate whether the settlement agreement signed by the NAF Subsidiaries affects NAF's claim, when that agreement was intended to benefit the Subsidiaries and thus NAF as the owner of their equity. It may be that the unusual characteristics of the contract at issue in this case, the creation of subsidiaries who were signatories to the merger agreement, and the subsidiaries' resolution of their dispute with Hampshire will affect the viability of NAF's breach of contract claim and its ability to prove compensable

Page 182

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. The Clerk is directed to transmit this opinion to the Second Circuit.


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