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LVI Group Investments, LLC v. NCM Group Holdings, LLC

Court of Chancery of Delaware

March 29, 2017

LVI Group Investments, LLC
NCM Group Holdings, LLC and Subhas Khara,

          Date Submitted: December 2, 2016

          John L. Reed, Esquire Ethan H. Townsend, Esquire DLA Piper LLP.

          Rudolf Koch, Esquire J. Scott Pritchard, Esquire Matthew D. Perri, Esquire Richards, Layton & Finger, P.A.

          Bradley R. Aronstam, Esquire Nicholas D. Mozal, Esquire.

          Richard D. Heins, Esquire Peter H. Kyle, Esquire Ashby & Geddes.

          John A. Sensing, Esquire Potter Anderson & Corroon LLP.

         Dear Counsel:

         This rather complex litigation can usefully be conceived in simplified form as follows. Two large demolition firms-Delaware LLCs-merged their businesses into a single entity, NorthStar Group Holdings, itself a Delaware LLC of which the firms became the members (the "Merger"). The percentage ownership of the member LLCs in NorthStar was based on a formula pegged to each LLC's financial statements prior to the Merger. These financial statements, in turn, were subject to certain representations and warranties from each LLC. The parties to the Merger agreed to indemnify one another for breaches of the merger agreement (the "Contribution Agreement"), including for inaccuracies in the representations and warranties, but such indemnification is capped at $15 million. The Contribution Agreement provides for unlimited recovery for fraud, however. Both parties, respectively via complaint and counterclaim, have alleged the other has committed fraud regarding its financial representations.

         Before me are the Counterclaim Defendants' (collectively, the "Counter-Defendants") Motions to Dismiss. The allegations of fraud against the Counter-Defendants-including one of the member LLCs, LVI Group Investments ("LVI"), and individuals associated with that entity-are pled in minimal fashion. At the motion to dismiss phase, however, the pleadings need only make ultimate recovery reasonably conceivable. It is true, as the Counter-Defendants point out, that elements of fraud must be pled with particularity, in order that a defendant may reasonably understand and defend the allegations against it. Here, however, I find the required elements pled: the Counterclaim Plaintiff-the other member LLC, NCM Holdings ("NCM")-alleges that LVI and its agents made certain financial representations; that the representations were made to NCM in negotiating and consummating the NorthStar merger, including with respect to NCM's percentage ownership; that these representations have proved false or inaccurate; that the Counter-Defendants knew the representations were false when made; and that NCM reasonably relied thereon to its detriment, while LVI profited from the false representations. This is sufficient particularity in a pleading of fraud to withstand dismissal. It is true, as the Counter-Defendants point out, that a required element- these parties' knowledge and intent regarding the falsity of the representations-is pled in a general averment. Knowledge, however, is not an element of fraud that must be pled with particularity. Accordingly, I find that the fraud allegations survive this motion to dismiss.

         The Counter-Defendants also seek to dismiss claims, brought by NCM both directly and derivatively on behalf of NorthStar, against current and former officers of NorthStar, who, NCM alleges, acted in support of the fraudulent activities described above. Those allegations fail to state cognizable claims. My rationale follows.

         I. BACKGROUND[1]

         A. The Parties

         Counterclaim Plaintiff NCM is a Delaware limited liability company and a member of NorthStar, of which NCM owns 37.5%.[2] Counterclaim Defendant LVI is a Delaware limited liability company and also a member of NorthStar, of which it owns 62.5%.[3] Prior to the Merger, NCM and LVI were competitors that were each engaged in the "business of demolition and remediation of large-scale projects."[4]

         Nominal Defendant NorthStar is a Delaware limited liability company formed by the Merger.[5] NorthStar's Board of Directors (the "Board") is comprised of eleven individuals.[6] Counter-Defendant Scott State is an owner of LVI and was "one of the persons who caused LVI to merge with NCM."[7] Leading up to the Merger, State was a managing member of LVI and LVI's President and CEO.[8] State was also President and CEO and a member of the boards of several LVI subsidiaries.[9] Prior to the Merger, State "participated materially in the management of LVI" and, after the Merger, State "continues to participate materially in the management of NorthStar."[10]

         Counter-Defendant Paul Cutrone is an owner of LVI and "was one of the persons who caused LVI to merge with NCM."[11] Leading up to the Merger, Cutrone was the Vice-President and CFO of LVI and several of its subsidiaries, as well as a member of the subsidiaries' boards.[12] Cutrone "participated materially in the management of LVI before the Merger and NorthStar after the Merger."[13] LVI, Cutrone, and State collectively comprise the Counter-Defendants.

         B. The Merger

         LVI approached NCM in September 2013 about a strategic merger between the two companies.[14] Initially, NCM was not interested in the proposed merger due to recently restructuring its debt and equity.[15] LVI continued its pursuit, however, and NCM eventually relented and agreed to discuss a merger.[16] LVI and NCM executed a non-disclosure agreement and negotiated throughout the end of 2013 and into the beginning of 2014.[17] Eventually, LVI and NCM agreed on a 62.5/37.5 split, "with LVI receiving 62.5% of the new company and NCM receiving 37.5% thereof."[18]

         On or about April 23, 2014, LVI and NCM "contributed and merged their subsidiaries" into a newly formed entity, NorthStar, pursuant to their merger agreement, the Contribution Agreement.[19] "State and Cutrone became CEO and CFO of NorthStar, respectively, " although NorthStar now no longer employs Cutrone.[20] "Pursuant to the Contribution Agreement, LVI submitted consolidated financial statements of the subsidiaries it was contributing to NCM" (the "LVI Financial Statements").[21] LVI represented and warranted in the Contribution Agreement that the LVI Financial Statements

fairly present, in all material respects, the consolidated financial position of the LVI Subsidiaries as of their respective dates, and the consolidated results of operations and cash flows of the LVI Subsidiaries for the respective periods covered thereby, in conformity with GAAP consistently applied throughout the period covered thereby . . . .[22]

         LVI also agreed to indemnify "and hold harmless [NorthStar] and each of its Subsidiaries from and against all Losses arising out of, relating to or resulting" from any inaccuracy in LVI's representations and warranties with respect to the LVI Financial Statements.[23] The Contribution Agreement also included a notice and claim procedure "pursuant to which NCM could bring a claim to enforce LVI's indemnity obligation to NorthStar" and provided that "the parties' exclusive remedies in connection with the Merger were" indemnification claims, which the Contribution Agreement capped at $15 million, and fraud claims, which were not capped.[24]

         C. Post-Merger Facts Leading to this Litigation

         Soon after the Merger, NorthStar began recognizing losses on the LVI legacy jobs.[25] NCM served a claim notice on LVI on April 21, 2015 alleging that the LVI Financial Statements were materially misstated because of improper accounting for ongoing jobs.[26] The Contribution Agreement required the parties "to cooperate and assist in all reasonable respects regarding the investigation and resolution" of a party's claim.[27] Accordingly, the parties engaged in an investigation of NCM's claim notice and this litigation commenced thereafter.[28]

         D. Procedural History

         LVI, not NCM, filed the first complaint in connection with the Merger on March 3, 2016 alleging fraud, fraudulent inducement, and unjust enrichment and pleading claims for indemnification and a declaratory judgment against NCM with respect to certain representations and warranties NCM made in the Contribution Agreement (the "LVI Complaint"). More specifically, LVI alleges that NCM intentionally overstated earnings and manipulated NCM's accounting in violation of GAAP in such a way that an auditor or purchaser would be unlikely to detect.[29]NCM, in turn, filed its Original Verified Counterclaim on April 4, 2016 and subsequently filed its Amended Verified Counterclaim on August 9, 2016, pleading five counts that are similar to the LVI Complaint. Count I is a claim for fraud against the Counter-Defendants and NorthStar alleging that the Counter-Defendants knowingly made or caused to be made false representations of material facts in the LVI Financial Statements and knowingly misrepresented that the LVI Financial Statements were prepared in accordance with GAAP.[30] Count I alleges further that the Counter-Defendants concealed substantial losses they knew would occur "that were not reflected in the LVI Financial Statements."[31] Count II is a claim for fraudulent inducement against the Counter-Defendants and NorthStar alleging, similar to Count I, that the Counter-Defendants "made or caused to be made false representations of material facts in the LVI Financial Statements" and that the Counter-Defendants misrepresented that the LVI Financial Statements were prepared in accordance with GAAP. Count II also alleges that the Counter-Defendants "orally and in writing further misrepresent[ed] to NCM that LVI's Jobs were properly reported in the LVI Financial Statements" and concealed substantial losses the Counter-Defendants knew would occur.[32] Count III is a claim for indemnification against LVI alleging that LVI's representations and warranties with respect to the LVI Financial Statements were not accurate and arguing that LVI must indemnify NCM pursuant to the Contribution Agreement.[33] Count IV alleges that Cutrone and State breached their fiduciary duties of care and loyalty to NorthStar and its members, including NCM, by, among other things, knowingly failing to follow GAAP, manipulating NorthStar's financial statements, manipulating costs and revenues of LVI jobs, and inducing LVI to file its claim against NCM. [34] Count V is a derivative claim for breach of fiduciary duty brought by NCM on behalf of NorthStar against Cutrone and State asserting that Cutrone and State's intentional failure to comply with GAAP and manipulation of NorthStar's financial reporting harmed NorthStar.[35]

         NCM seeks damages, in an amount to be proven at trial, of not less than $223 million for Counter-Defendants' alleged fraud, and equitable reformation of the Contribution Agreement to lower LVI's allocated equity in NorthStar.[36] NCM also asks for the maximum amount of indemnification under the Contribution Agreement, $15 million. It seeks a finding that Cutrone and State, as officers of NorthStar, breached their fiduciary duties of care and loyalty to NCM and to NorthStar, an order removing State as an officer of NorthStar, and an order compelling both Cutrone and State to forfeit any compensation received from NorthStar while they were in breach of their fiduciary duties to NorthStar.[37]

         On August 23, 2016, the Counter-Defendants moved to dismiss the various counts against them. State and Cutrone moved to dismiss Counts I, II, IV, and V under Court of Chancery Rules 8(a), 9(b), 12(b)(6), and 23.1. Cutrone also moved to dismiss all counts against him under Court of Chancery Rule 12(b)(2) for lack of personal jurisdiction. NorthStar moved to dismiss Count V under Rule 23.1. LVI moved to dismiss certain counts against it in part, focusing particularly on NCM's allegations of fraud pertaining to additional jobs that were not alleged in NCM's Original Verified Counterclaim. I heard oral argument on the Counter-Defendants' motions on December 2, 2016. My Letter Opinion follows.

         II. ANALYSIS

         The various Counter-Defendants have moved to dismiss certain counts of the Counterclaim pursuant to Rule 12(b)(6) for failure to state a claim. When evaluating a motion to dismiss under 12(b)(6), the Court accepts well-pleaded factual allegations as true, drawing all reasonable inferences in favor of the non-moving party.[38] The Court must deny the motion unless "the [non-moving party] could not recover under any reasonably conceivable set of circumstances susceptible of proof."[39] NCM asserts both fraud and fiduciary duty claims against the Counter-Defendants. I address each in turn below.[40]

         A. The Fraud Claims

         Counts I and II assert claims for fraud against Counter-Defendants LVI, State, and Cutrone. The Counter-Defendants moved to dismiss these claims under Rule 9(b), arguing that NCM has failed to plead fraud with the required level of particularity. To claim fraud, a plaintiff must plead, "(i) a false representation, (ii) the defendant's knowledge of or belief in its falsity or the defendant's reckless indifference to its truth, (iii) the defendant's intention to induce action based on the representation, (iv) reasonable reliance by the plaintiff on the representation, and (v) causally related damages."[41] Court of Chancery Rule 9(b) requires a plaintiff to plead fraud with particularity.[42] The particularity requirement "means that a plaintiff must allege the circumstances of the fraud with detail sufficient to apprise the defendant of the basis for the claim."[43] "The relevant circumstances are the time, place, and contents of the false representations; the facts misrepresented; the identity of the person(s) making the misrepresentation; and what that person(s) gained from making the misrepresentation."[44] However, Delaware courts have held that lack of specificity as to date, place, and time are not fatal, provided that the pleadings put defendants on sufficient notice of the actual misconduct with which they are charged.[45]

         When, as here, a plaintiff's claim for fraud is based on a written contractual representation, it is "relatively easy [for a plaintiff] to plead a particularized claim of fraud."[46] In such a situation, the plaintiff "can readily identify who made what representations where and when [and] what the defendant gained, which was to induce the plaintiff to enter into the contract."[47] At that point, the plaintiff "need only allege facts sufficient to support a reasonable inference that the representations were knowingly false."[48] Importantly, a defendant's state of mind, such as its knowledge and intent, "may be averred generally, " or, in other words, a plaintiff "need only point to factual allegations making it reasonably conceivable that the defendants charged with fraud knew the statement was false."[49] More specifically, where a plaintiff is pleading a claim of fraud "that has at its core the charge that the defendant knew something, there must, at least, be sufficient well-pleaded facts from which it can reasonably be inferred that this 'something' was knowable and that the defendant was in a position to know it."[50] NCM has met such a standard here.

         NCM alleges in Counts I and II that LVI, with the direct participation of State and Cutrone, intentionally manipulated revenues, costs and profit margins to hide losses and knowingly misrepresented that the LVI Financial Statements were prepared in accordance with GAAP (the "Fraud Claims").[51] NCM then presents six specific jobs as examples of LVI's "pattern and practice of failing to recognize revenue and losses in accordance with GAAP" (the "Investigated Jobs").[52] Having allegedly established a pattern and practice, NCM alleges further fraud with respect to other additional jobs, including seventeen specific jobs, based on discovering "evidence of the same improprieties in their accounting treatment as NCM found in the Investigated Jobs" (the "Additional Jobs").[53]

         As an initial matter, the Counter-Defendants do not dispute, and I assume for purposes of addressing these motions, that the fraud claims here can adequately be brought against State and Cutrone[54] personally as well as against LVI. I turn, then, to the adequacy of the complaint against the Counter-Defendants. Based on the allegations of the Counterclaim, I find that NCM has adequately alleged facts that, if true, demonstrate fraudulent representation by the Counter-Defendants.

         The LVI Financial Statements stated certain amounts of profits and losses for particular jobs. After the Merger, profits and losses on those jobs proved lesser and greater, respectively. As a result, the assets contributed by LVI to NorthStar appeared misleadingly more valuable, affecting the allocation of equity in NorthStar between LVI and NCM. At this stage, these allegations are enough for me to infer a misrepresentation in the Contribution Agreement. Therefore, because NCM's fraud claims here are based on a written contractual representation, all that remains to decide this matter is whether NCM has adequately pled knowledge on the part of State, Cutrone, and LVI.[55]

         To my mind, and in light of the low pleading standard at the motion to dismiss stage, NCM has alleged sufficient facts from which I can generally infer knowledge on behalf of the Counter-Defendants. The Counter-Defendants had access to the financial data and chose how to report it. They stood to gain financially from an overstatement of value in their financial statements. Further, NCM alleges that the Counter-Defendants "knew that at least some of the Jobs were misstated on the LVI Financial Statements, " and knew before the Merger that "there would be millions of dollars in [undisclosed] losses" on some jobs.[56] NCM also alleges that "[i]nternal correspondence among LVI's management team, including Cutrone and State, show that management knew that losses were imminent, but opted not to take them when they should have been taken . . . to avoid negatively affecting the LVI Financial Statements" before the Merger.[57] These facts are sufficient for me to infer that the truth regarding the LVI financial averments was indeed "knowable" by the Counter-Defendants here and that they were in a position to know it. Accordingly, while NCM may have a difficult climb in proof of its claims at summary judgment or trial, NCM has adequately alleged knowledge on the part of the Counter-Defendants.[58]NCM, I find, has sufficiently apprised these parties of the claim against them to satisfy the requirements of Rule 9(b). Thus, NCM's claims for fraud and fraudulent inducement in Counts I and II against State, Cutrone, and LVI survive the Motion to Dismiss.[59]

         B. The Fiduciary Duty Claims

         NCM alleges that State, and formerly Cutrone as well, used their positions as officers at NorthStar to effectively conceal the fraud described in Counts I and II. NCM seeks to bring fiduciary duty claims either directly or derivatively for these actions. These claims, at first glance, appear viable, but on closer examination fail to state a claim as pled.

         In Count IV, NCM asserts a direct claim against State and Cutrone, as officers of NorthStar, for violating their fiduciary duties to NCM, as a member of NorthStar.[60] NCM also asserts a derivative claim in Count V on behalf of NorthStar against State and Cutrone for violating their alleged fiduciary duties to NorthStar. State and Cutrone moved to dismiss both of these Counts pursuant to Rule 12(b)(6) and, along with NorthStar, to dismiss Count V pursuant to Rule 23.1 for failure to make a demand on the NorthStar Board.

         1. NCM fails to state a direct claim with respect to Count IV

         As our Supreme Court recently clarified,

"whether a claim is [direct or derivative] must turn solely on the following questions: (1) who suffered the alleged harm (the corporation or the suing stockholders, individually); and (2) who would receive the benefit of any recovery or other remedy (the corporation or the stockholders, individually)? In addition, to prove that a claim is direct, a plaintiff 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."[61]

         In Count IV, NCM alleges that State and Cutrone, as CEO and CFO of NorthStar, respectively, owed fiduciary duties "to NorthStar and its members, including NCM."[62] According to NCM, State and Cutrone breached these duties by:

a) Knowingly failing to follow GAAP for the purpose of manipulating NorthStar's revenues, assets and profits on NorthStar's financial statements to the detriment of NCM and to encourage and support LVI to assert claims against NCM;
b) Manipulating costs and revenues to artificially preserve profit margins on LVI legacy jobs;
c) Shifting costs between unrelated jobs to manipulate profits and losses on jobs in order to have LVI legacy jobs appear more profitable and NCM legacy jobs appear less profitable;
d) Carrying [certain debt] on NorthStar's books that they know [is] not likely to result in cash collections in order to make LVI legacy jobs appear more profitable;
e) Orchestrating a fraudulent "look back" analysis designed to manipulate NorthStar's reported profits and losses and favor LVI over NCM in their current dispute relating to their Merger by devaluing the jobs NCM contributed to the Merger all for the purpose of covering up their own ...

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