What to Tell Your Investor Limited Partners (or Stockholders or LLC Members)

A Delaware Supreme Court case earlier this year, Dohmen v. Goodman (Del. June 23, 2020), provides authoritative guidance on the duty of disclosure of management to stockholders, limited partners and members of limited liability companies. The case is of particular relevance to private investment vehicles, whose stockholders, partners or members, at various times during the life of their investment, are either solicited for consent or investment, or have contractual rights or obligations to acquire or sell equity interests. In circumstances where controllers have a duty of full disclosure in connection with such a transaction but fail to provide that disclosure, they could be liable for damages to investors that are traceable to the failure to disclose. As discussed in Dohmen, however, a duty of full disclosure does not exist in all cases, and where there is no such duty, management may only be liable for its actual misstatements. Knowing when a company is required to provide full disclosure to its investors — as opposed to when it is only required to be truthful — can inform the type of information provided to investors in connection with M&A and other the major life-cycle events of a private investment vehicle.

The Facts of the Dohmen Case

In 2010, Bert Dohmen, well known in the financial services industry for his newsletters analyzing financial markets and world economies, started a hedge fund. Dohmen formed the fund in Delaware as a limited partnership, and created a Delaware limited liability company to serve as the general partner with exclusive control and management of the fund. Dohmen was the sole member and manager of the general partner.

Dohmen reached out to Albert Goodman, who was interested in becoming a limited partner. When Goodman asked Dohmen how many others he expected would invest and become limited partners of the fund, Dohmen obfuscated. He explained that he had yet to officially announce the fund, and only a couple of his good friends, including Goodman, even knew about the fund’s existence. Before receiving any further clarification as to the number of expected limited partners, Goodman executed a subscription agreement and made a $500,000 capital contribution, becoming the fund’s first (and only) limited partner.

About a week later, prior to making a second capital contribution, Goodman inquired again as to the expected number of limited partners of the fund, to which Dohmen replied via email that the fund’s existence was still unknown to most people. A few days later, Goodman asked Dohmen again about other investors, and Dohmen explained that “[p]ersonal friends that have expressed interest are now reviewing the documents.”

Eventually, Dohmen confessed to Goodman that there were no other limited partners of the fund, and within a short time, the value of the net assets of the fund was greatly diminished. Goodman filed suit against Dohmen in federal district court in California, seeking damages for the substantial loss of his investment. The district court held that Dohmen had made a knowing misrepresentation with respect to the second investment and that, having solicited “shareholder action,” this was a breach of his fiduciary duty to Goodman. The district court acknowledged that this misrepresentation was not the cause of Goodman’s loss, which was a consequence of market factors. However, as the district court understood Delaware law, Goodman was not required to prove loss causation in these circumstances, and awarded Goodman damages.

The Delaware Supreme Court Decision

Dohmen appealed to the Ninth Circuit Court of Appeals, which certified a question of law to the Delaware Supreme Court. As reframed by the Delaware Supreme Court, that question was twofold:

• Does a general partner’s request for a one-time capital contribution constitute a request for limited partner action, such that the general partner has a duty of disclosure?
• If the general partner fails to disclose material information in connection with the request, may the limited partner prevail on a breach of a fiduciary duty claim and recover compensatory (as opposed to nominal) damages without proving reliance and causation?

Does the form of entity make a difference?

The Dohmen case involved a limited partnership. In its analysis, however, the Delaware Supreme Court applied familiar fiduciary duty concepts from the law of corporations. While limited partnerships and limited liability companies can modify, within limits, the fiduciary duties owed by management to investors, in the absence of such modification, the legal principles articulated by the court in Dohmen should apply equally to corporate and noncorporate investment vehicles.

What is a “request for stockholder action,” and why does it matter?

The court’s decision turned on the existence or absence of a “request for stockholder action.” If management’s interaction with investors constitutes a request for stockholder action, management has an affirmative duty to disclose “fully and fairly all material facts within [its] control bearing on the request,” and the failure to make that disclosure constitutes a breach of management’s duty of loyalty to the investors. In the absence of a request for stockholder action, management has no such duty of disclosure. Outright deception, however, constitutes a breach of management’s duty of loyalty in all circumstances and is actionable by investors.

Central to the court’s decision in Dohmen was therefore its articulation of a standard for what constitutes a “request for stockholder action.” According to the court, a request for stockholder action occurs when management approaches a group of investors with a request for discretionary action. An approach to a single investor, the fulfillment by investors of a contractual obligation, or the unsolicited exercise by investors of a contractual right would not constitute a “request for stockholder action.”

The availability of damages

In response to the certified question of the Ninth Circuit, the Delaware Supreme Court also held that to recover more than nominal damages, an investor with a disclosure claim against management must prove reliance and causation. This principle applies with respect to both the duty to disclose in connection with a request for stockholder action and the obligation to be truthful in all circumstances.

The bottom line

Applying its holding to the facts of the case, the Delaware Supreme Court said that Dohmen’s approach to Goodman for an investment in the fund did not constitute a request for stockholder action. Dohmen had a duty to be truthful but had no fiduciary obligation to make full disclosure. Either way, however, Goodman could not obtain compensatory damages because the district court found he did not establish loss causation.

Why the Dohmen Case Matters

Investment actions and decisions are made by investors at various points in the life cycle of a private equity investment. In particular, during the endgame of an investment, the investors’ consent may be required for a business combination transaction or the investors may be subject to the exercise by majority holders of drag-along rights. Investors may be offered the opportunity to roll over some or all of their original investment into the acquirer. Investors may also be approached to enter into a new voting or investor rights agreement. Where a major equity holder is disposing of its position, minority investors may have contractual rights to tag along or exercise rights of first offer or first refusal.

The Delaware Supreme Court’s decision in Dohmen informs the level of disclosure that management is obligated to provide to investors in the different scenarios. Where investor action is being solicited — for example, where investors are asked to vote on a transaction or solicited to invest in the acquirer — management has an affirmative duty to make full and fair disclosure to investors. On the other hand, where minority investors are being dragged along in an exit transaction pursuant to previously negotiated contractual rights, management’s disclosure obligations will be limited to being truthful. Management may have no obligation to make disclosure, but it cannot lie.

The interplay with federal securities laws

The anti-fraud rules of the federal securities laws, particularly Section 10(b) of the Securities Exchange Act and famed Rule 10b-5, apply to transactions in the securities of private companies. Rule 10b-5 provides a private right of action where a party has engaged in deceptive practices, including intentionally or recklessly making false or deficient disclosures in connection with the purchase and sale of stock, limited partnership interests and limited liability company interests. There are, however, circumstances in which a private right of action under the federal securities laws may be unavailable to an investor, but the investor may, subject to demonstrating loss causation and reliance, have a state law claim. These might include:

• Where an investor refrains from taking action owing to information that management has a duty to disclose but fails to provide. In such a case Rule 10b-5 is unavailable because no purchase or sale of a security occurred.
• Where management seeks a stockholder vote for an acquisition or disposition not involving the issuance of securities, but fails to make the disclosures required by its fiduciary duties. (The federal anti-fraud rules for proxy solicitations do not apply to private companies.)

State law may also inform the circumstances in which a Rule 10b-5 action may be available under federal law. For example, if under state law management has no affirmative duty of disclosure under the facts such as those in Dohmen —  the solicitation for investment of a single investor — it is possible that the purchasing investor may have no federal cause of action for failure to disclose all relevant facts and circumstances.

Conclusion

Directors and general partners need to understand when they have a duty to disclose all material information to their investors. Dohmen v. Goodman clarifies that, under Delaware law, this duty is limited in scope, but that in appropriate cases damages may be available to investors under Delaware law for a failure of disclosure.

The following table contrasts the application of federal securities laws and Dohmen v. Goodman to various scenarios involving a private company having multiple equity holders but not securities registered with the SEC. In each case, where a cause of action for damages is available to investors under Delaware law, a successful plaintiff must establish reliance and causation in order to be awarded more than nominal damages.