July 24, 2019

Delaware Chancery Court Addresses Potential Claimants and Period for Asserting Unlawful Dividend Claims

The Delaware Chancery Court recently issued an opinion addressing two issues of first impression relating to the categories of persons who can assert a claim under the state’s unlawful dividend statute and the period within which such a claim must be asserted. The decision provides clarity to directors on the period for which they may have liability and underscores the importance of complying with applicable restrictions on paying dividends.

Background

The case, JPMorgan Chase Bank, N.A. v. Claudio Ballard et al., arises from a 2005 licensing agreement between J.P. Morgan and Data Treasury Corporation (DTC) relating to settlement of a patent infringement lawsuit. In exchange for a license to DTC’s check imaging patents, J.P. Morgan paid $70 million to DTC, subject to J.P. Morgan’s right (under a most-favored licensee provision) to a refund if DTC licensed the same patents to another party on more favorable terms. DTC also agreed to provide J.P. Morgan notice of any licenses granted by DTC to the same patents licensed by J.P. Morgan.

Within months after entering into the license agreement with J.P. Morgan, DTC began licensing the applicable patents to other companies for payments substantially less than what J.P. Morgan paid to DTC and without providing J.P. Morgan notice of the licenses granted. One license granted by DTC in 2012 for the same patents, which was not promptly disclosed to J.P. Morgan, included a lump sum payment to DTC of only $250,000. J.P. Morgan ultimately learned of DTC’s subsequent licenses and obtained a judgment from the U.S. District Court for the Eastern District of Texas for $69 million in 2015, which remained unpaid when J.P. Morgan filed its complaint with the Chancery Court in 2018.

J.P. Morgan sued DTC, its directors at relevant times, and certain affiliates to recover, among other payments made by DTC, dividends DTC paid its stockholders from 2006 to 2010 under § 174 of the Delaware General Corporation Law (DGCL) and the Delaware Uniform Fraudulent Transfer Act (DUFTA).

The DGCL permits corporations to pay dividends out of their statutory surplus or, if there is no surplus, out of the corporation’s net profits for the fiscal year in which the dividend is declared or the preceding fiscal year. DGCL § 174 provides that, in the case of willful or negligent violations of the DGCL’s restrictions on dividend payments, directors who presided over payment of an unlawful dividend are jointly and severally liable at any time within six years of the payment of the unlawful dividend to (1) the corporation or (2) its creditors in the event of the corporation’s dissolution or insolvency. J.P. Morgan alleged that DTC’s board of directors willfully or negligently approved payment of more than $117 million of dividends at a time when DTC lacked sufficient surplus or net profits, that DTC was insolvent or rendered insolvent at the time of the dividends, and that the payments were made to avoid paying J.P. Morgan amounts due to it under its license agreement with DTC and subsequent judgment related to that agreement.

DTC filed a motion to dismiss for failure to state a claim. DTC’s motion included arguments that one must be a judgment creditor at the time of an allegedly unlawful dividend to be a “creditor” with standing to maintain a claim under § 174 and that J.P. Morgan’s claims with respect to certain dividend payments were not timely because the six-year limitations period in § 174 operates as a statute of repose rather than a statute of limitations to which tolling principles may be applied.

Analysis

DTC’s argument that J.P. Morgan did not have standing to sue under § 174 focused on the fact that J.P. Morgan did not obtain a judgment against DTC until 2015, but the challenged dividend payments occurred between 2006 and 2010. Because directors can only be liable to creditors under § 174, if J.P. Morgan needed a judgment to become a creditor under § 174, then it would not have a claim because it was not a creditor at the relevant times of payment.

Examining prior case law in Delaware and DUFTA, the Chancery Court disagreed with DTC’s narrow interpretation that a “creditor” under § 174 needed to have a judgment or lien to demonstrate its position as a creditor, rather than simply having a valid claim to an amount owed to achieve status as a “creditor” for purposes of the law. J.P. Morgan’s unliquidated claim against DTC during the relevant time period therefore was sufficient to establish its status as a creditor able to assert a claim under § 174.

Because more than six years had passed between the date in 2010 when DTC paid the last of the dividends that J.P. Morgan challenged and the date in 2018 when J.P. Morgan filed its complaint in the case, DTC sought to have J.P. Morgan’s § 174 claim dismissed as untimely based on the six-year period provided for in the statute being a strictly defined period that is not subject to tolling under various judicial doctrines. J.P. Morgan countered that six-year period in § 174 should be subject to tolling on various grounds allegedly present in this case, including DTC’s status as a private company not subject to public reporting requirements — which made DTC’s payment of dividends during the relevant period unknowable to an unrelated third party such as J.P. Morgan.

After examining the purpose of a statute of limitations (to encourage plaintiffs to diligently pursue known claims) and the purpose of a statute of repose (to provide certainty of protection to potential defendants against claims) as well as the statutory history of Delaware’s legislation on unlawful dividends, the Chancery Court concluded that the six-year period in § 174 is a statute of repose that begins to run on the date an unlawful dividend is paid and is not subject to tolling. The court’s conclusion was based on the language in § 174 tying the applicable period to a specified action (i.e., the payment of a dividend) in addition to the historical development of Delaware’s unlawful dividend statute. J.P. Morgan’s claim under § 174 therefore was dismissed for being untimely under the DGCL.

The Chancery Court, however, allowed J.P. Morgan’s alternative claim under DUFTA to recover certain dividends to proceed. DUFTA provides a separate statute of limitations from DGCL § 174 that requires a claim to be brought “within 4 years after the transfer was made or the obligation was incurred or, if later, within 1 year after the transfer or obligation was or could reasonably have been discovered by the claimant.” The court held that the 1-year period in DUFTA began to run when the fraudulent nature of a transfer — rather than merely the fact that a transfer occurred — was or could reasonably have been discovered, and that J.P. Morgan’s claim under DUFTA was timely and properly pled based on the facts in its complaint.

Why It Matters

The Ballard case is a good reminder of the power of “most favored nations” provisions in contracts. The most-favored licensee provision in J.P. Morgan’s license agreement with DTC gave rise to the significant damages that resulted in DTC’s insolvency and made pursuing the fraudulent transfer and unlawful dividend claims against DTC’s directors worthwhile. The economic harm that can result from granting most-favored status to a counterparty and — although allegedly not the situation in the Ballard case — the relative ease with which such provisions can be breached unintentionally are significant reasons that parties usually strongly resist such provisions. The potentially significant benefit that purchasers and licensees gain from the protections that a most-favored provision provides, as this case demonstrates, of course are the reason that parties with significant leverage should seek to include such provisions in agreements.

The Chancery Court’s broad interpretation that “creditors” for purposes of § 174 are not limited to judgment creditors and can include persons with unliquidated claims provides insight into a topic that had not been examined in detail in prior cases. While directors remain subject to a willful or negligence standard to be liable under § 174, the Ballard ruling creates an expansive class of potential claimants under the statute and emphasizes the importance of directors focusing on compliance with the DGCL’s restriction on dividend payments when declaring and paying dividends to stockholders.

Finally, the Chancery Court’s holding that the six-year period set forth in § 174 is a statute of repose provides directors of Delaware corporations who approve dividends or stock repurchases covered by the law a clearly defined period during which they might have liability for their actions. The holding also puts creditors on notice of the need to both discover and pursue their claims within that period to have a valid claim under the law. As the Ballard case demonstrates, however, an alternative theory of recovery might apply under DUFTA — even if a claim under § 174 is time-barred.

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