A recent opinion issued by the Delaware Court of Chancery in Stone & Paper Investors LLC v. Blanch resolved dueling allegations of corporate mismanagement and fraud that pitted a pair of long-time business partners against their protégé and his associates. In the 100+ page opinion, Vice Chancellor Paul A. Fioravanti, Jr., described a years-long scheme to induce a multi-million dollar investment in a new stone-based paper venture and then, when that venture fizzled, to drain the invested funds for personal gain in a series of undisclosed interested transactions. The facts of this case are extreme and involve an extended pattern of intentional wrongdoing. However, as an illustration of what can happen when bad actors take control, Stone & Paper provides important guidance to honest managers and other interested parties who draw salaries from, or otherwise transact with, the companies they control. Interested parties who engage in such transactions should take care that the material facts underlying any interested transactions have been fully disclosed and that they have complied with the requirements of the operating agreement, including documenting any necessary approvals. And if, by inadvertence or mistake, managers fail to secure the necessary approval for these transactions in advance, they should disclose all of the material facts as promptly as possible after the fact, such that the Board may be deemed to have acquiesced in the transactions.
In 2014, business partners John Diamond and Albert Carter formed Stone & Paper Investors, LLC, to invest $3.5 million in Clovis Holdings, LLC, a new venture formed and managed by their protégé, Brian Skinner – who Diamond and Carter had come to regard as family over their years together – and a new associate, Richard Blanch. Clovis was formed to acquire ViaStone, a business with rights to distribute paper products made from stone. Stone & Paper’s investment represented the fruition of a plan hatched by Skinner and Blanch to squeeze profits from Skinner’s relationship with Diamond and Carter.
Shortly after forming Clovis, both Skinner and Blanch began drawing a salary of $20,000 per month, which they characterized as management fees or consulting fees. Diamond gave permission for Skinner to draw a salary for his management services, but did not approve any payments to Blanch or his associates. Skinner and Blanch nevertheless wired equivalent monthly payments to Blanch in the guise of “consulting” fees to one of his companies (though no consulting services were ever provided).
Throughout most of 2014 and 2015, Skinner and Blanch devoted Clovis’s resources to efforts to acquire ViaStone, as required under the LLC agreement. However, by November 2015, they had abandoned that effort. At that point, they began to drain Clovis’s accounts, diverting its funds to alternative investments (without approval from Stone & Paper) or to pay their personal attorneys, credit card bills, and other personal expenses. They recharacterized many of these payments directed to themselves as “loans” or advances on management fees to conceal their activities. By May 2018, when this scheme was uncovered by an observant accountant, Skinner and Blanch had transferred $2.5 million from Clovis to themselves or their affiliates. Clovis was left with only $6,500 in its accounts.
Upon discovering these facts, Stone & Paper filed suit against Skinner and Blanch, alleging that they had fraudulently induced Stone & Paper to invest in Clovis, and then misappropriated the capital for their own personal use, in violation of both the operating agreement and their fiduciary duties to the company. Skinner and Blanch, in turn, directed Clovis to assert counterclaims alleging that Stone & Paper also breached the operating agreement and misappropriated company funds by causing Clovis to pay more than $100,000 in unauthorized credit card charges.
After a four-day trial, the Court found that, although Stone & Paper’s initial investment had not been fraudulently induced, Skinner and Blanch had breached various provisions of the LLC agreement, violated their fiduciary duties to Clovis, and fraudulently concealed their conduct from Stone & Paper. In addition, the Court held that several of Skinner and Blanch’s affiliates were liable for civil conspiracy and aiding and abetting.
This decision raises one issue of particular note for readers of this blog, who we assume are not fraudulently diverting corporate assets: Stone & Paper’s accusation that Skinner and Blanch engaged in a series of interested transactions framed as either management fees, consulting fees, or loans, depending on the context, which collectively drained Clovis’s accounts of more than $2.5 million. Interested transactions between Clovis and its managers were prohibited under the terms of the LLC agreement – as they are under many operating
agreements – unless first determined to be in the interest of the company and fully disclosed to and approved by the Board of Directors. Skinner and Blanch did not deny that they had engaged in interested transactions, but defended against Stone & Paper’s claims by asserting that Stone & Paper had acquiesced in those transactions.
Under Delaware law, to prove the affirmative defense of acquiescence, the defendant must prove that the acquiescing party had “full knowledge of [its] rights and the material facts” and “(1) remain[ed] inactive for a considerable time; (2) freely [did] what amount[ed] to recognition of the complained of act; or (3) act[ed] in a manner inconsistent with the subsequent repudiation, which le[d] the other party to believe the act ha[d] been approved.” Basho Techs. Holdco B, LLC v. Georgetown Basho Inv., LLC, 2018 WL 3326693, at *41 (Del. Ch. July 6, 2018) (internal citations omitted). With one exception, the Court found that the managers had failed to satisfy this standard.
The Court first found no documentary evidence indicating that Stone & Paper had approved in advance either the monthly fees paid to Blanch and his associates or the “loan” payments to Skinner and Blanch. The Court reached the opposite conclusion as to the management fees paid to Skinner only because Diamond testified that he had consented to such payments shortly after investing in Clovis, with full knowledge that Clovis had not yet acquired ViaStone. Next, the Court determined that there was no evidence that Stone & Paper had acquiesced in the remaining interested transactions, which had not been approved in advance. The single email Skinner and Blanch relied on as having notified Diamond in November 2016 that they had been receiving management fees or loans was not sufficient to prove “acquiescence” because it (i) did not provide “full knowledge of the material facts about the purpose of the payments or the fact that the payments began” more than two years earlier, and (ii) conveyed the “fabrication” that management fees paid over the course of several years should be recharacterized as loans. The Court concluded: “Because [Stone & Paper] did not have ‘full knowledge of [its] rights and the material facts,’ [Stone & Paper] could not have acquiesced to the payment of the Management Fees” or to “loans that were not, in fact, loans.” The Court therefore found Skinner and Blanch liable to Stone & Paper.