A recent Texas Court of Appeals case held that members of a Delaware limited liability company (LLC) can contract around (i.e., waive) the general principle protecting against usurpation of corporate opportunities. This decision is of particular importance to private equity owners that may hold other investments in companies in the same industry and closely follows recent Delaware case law. The case also should limit the ability for parties to forum shop and seek to obtain a different outcome on Delaware legal issues by filing in another forum, in this case Texas.
On December 8, 2020, a Texas Court of Appeals case affirmed the dismissal of a breach of contract claim based on the implied duty of good faith and fair dealing under Delaware law brought by minority members in a midstream oil and gas company against a private equity firm — the company’s majority member. The minority members alleged that the private equity firm usurped the company’s corporate opportunities by investing in opportunities allegedly identified by the minority members. The decision held that under Delaware law (the law governing the operating agreement) there is no breach of an implied duty when the operating agreement expressly permits other members to invest in such opportunities without offering the opportunity to the company.
This is Part 1 in a two-part series discussing developments around contractual waivers of the corporate opportunity doctrine in the private equity realm.
In Patterson v. Five Point Capital Midstream Funds I and II, L.P., Case No. 01-19-00643-CV (Tex. App. Dec. 8, 2020), minority members (Patterson) in a midstream oil and gas company (Redwood) filed suit against the majority partner and related entities (Five Point) alleging breach of contract and claims for fraud, unjust enrichment, quantum meruit, and conversion for allegedly usurping investment opportunities from Redwood. Five Point invested in three investments, which “Patterson claim[ed] that it identified [as] potential investments for Five [Point].” “Five Point is a private equity firm that specializes in the midstream section of the oil and gas industry” and “Patterson alleged that all investment opportunities that it ‘found, identified, and targeted’ belonged to Redwood and that Five Point breached its duty of good faith and fair dealing by usurping those opportunities.”
Five Point moved to dismiss under Texas Rule of Civil Procedure 91a, which permits a party to move to dismiss a cause of action if it has no “basis in law or fact.” In Patterson, the trial court dismissed all causes of action under Rule 91a and the Texas Court of Appeals affirmed.
Breach of Contract/Duty of Good Faith and Fair Dealing
Patterson brought a claim for breach of contract, specifically the breach of the implied duty of good faith and fair dealing under Delaware law. Patterson alleged that Five Point breached its duty of good faith and fair dealing by usurping “investment opportunities” that belonged to the company, Redwood, by funding investment targets identified by Patterson. In other words, Patterson claimed that the Operating Agreements contained an implied covenant that Five Point would invest in opportunities identified by Patterson only through Redwood. The Court held that Patterson lacked standing to bring the breach of contract claim and in any event that there was no breach of the implied covenant of good faith and fair dealing under Delaware law when the operating agreement expressly permitted Five Point to invest in the opportunities.
The Court explained that the operating agreements “provide[d] that Five Point is ‘free to engage or invest in an unlimited number of other activities or businesses, any one of which may be related to or competitive with the Business, without having or incurring any obligation under this Agreement to offer any interest in such activities to Company.’” The Court held that “Patterson cannot use the implied duty of good faith and fair dealing to recreate a fiduciary duty that has been explicitly waived in the contract.”
The decision also affirmed the dismissal of Patterson’s non-contractual claims under Texas law for fraud, unjust enrichment/quantum meruit, and conversion. The Court held there could be no justifiable reliance on alleged representations that Five Point would invest in opportunities identified by Patterson through Redwood to support its fraud claim because that conflicted with the express corporate opportunities waiver. Moreover, there was no claim for unjust enrichment/quantum meruit because a valid contract governed and conversion failed because the allegation that Patterson was entitled to a share of distribution from the investments was not a proper subject to conversion.
This decision follows a trend in Delaware that permits parties to contract around the traditional rules prohibiting usurpation of corporate opportunities. See Alarm.com Holdings, Inc. v. ABS Capital Partners Inc., No. CV 2017-0583-JTL, 2018 WL 3006118 (Del. Ch. June 15, 2018), aff’d, 204 A.3d 113 (Del. 2019).
In December 2019, the Delaware Supreme Court in Alarm.com affirmed a decision penned by Vice Chancellor J. Travis Laster out of the Court of Chancery dismissing a claim under the Delaware Uniform Trade Secrets Act. The complaint in that case alleged that a private equity firm misused the corporation’s confidential information by investing in the competitor and brought claims for misappropriation of trade secrets against the private equity funds. The decision held there was no misappropriation of trade secrets because the parties contemplated the firm would invest in opportunities. This case gives a strong indication that Texas courts will follow Delaware precedent and not permit contractual and extra-contractual claims when there is a waiver of corporate opportunities. As such, it should give comfort to the large number of private equity firms with investment in Delaware LLCs with primary operations in Texas.
Keep an eye out for Part 2 of this series, which will take a deeper dive into Alarm.com, the open questions it left, and potential new developments concerning waiver of usurpation of corporate opportunities in the private equity realm.
This post is as of the posting date stated above. Sidley Austin LLP assumes no duty to update this post or post about any subsequent developments having a bearing on this post.