Case Alert: MALT Family Trust v. 777 Partners LLC

A recent decision from Delaware highlights the importance of expressly memorializing contracting parties’ understandings and expectations in M&A transactions involving contingent earnout consideration and/or rollover equity consideration. The decision, which addresses various post-closing disputes between a rollover seller and the buyer’s financial sponsor, serves as a reminder that sellers should carefully consider appropriate earnout covenants, particularly if satisfaction of applicable performance metrics is likely to hinge on the buyer’s use of the target as its exclusive platform for engaging in the relevant business. For financial sponsors seeking flexibility to operate more than one portfolio company in the same industry, the decision underscores the need to draft appropriate waivers in the relevant organizational documents with precision.         

Background

MALT Family Trust v. 777 Partners LLC (Del. Ch. Nov. 13, 2023) centers on a stock purchase agreement pursuant to which plaintiffs Timothy O’Neil-Dunne and MALT Family Trust sold all outstanding equity in two entities in the aviation business to an affiliate of the principal defendant, 777 Partners LLC. In consideration for the transaction:

• O’Neil-Dunne and the MALT Trust were paid cash.
• The MALT Trust was issued a 3% fully vested equity interest in a newly formed company, Phoenicia LLC.
• The MALT Trust received an additional 3% unvested interest in Phoenicia, which was subject to time-based vesting in three equal portions over the ensuing three years.
• The MALT Trust received an additional 2% unvested interest in Phoenicia in the form of restricted warrants, which the MALT Trust could convert into vested interests in Phoenicia subject to the achievement of certain milestones.

The parties also entered into certain agreements ancillary to the stock purchase agreement, including Phoenicia’s operating agreement and an employment agreement between O’Neil-Dunne and 777 Partners, which provided that the MALT Trust would forfeit 1% of its vested interest in Phoenicia if the employment agreement were terminated within the first four years.

Plaintiffs O’Neil-Dunne and the MALT Trust claimed that during the 10-month negotiation of the stock purchase agreement, defendants 777 Partners and its founders and CEO, who are individual defendants named in the decision, represented that their aviation-related businesses would be operated through Phoenicia exclusively. However, a few years after closing, the plaintiffs discovered that the defendants had been operating two new business lines related to aircraft leasing outside of Phoenicia.

The plaintiffs brought claims for, among other things, (1) breach of fiduciary duties by usurping business opportunities of Phoenicia, (2) breach of contract, by failing to convey to the MALT Trust the full equity interest in Phoenicia to which it was entitled under the stock purchase agreement and Phoenicia’s operating agreement, on the basis that certain applicable earnout milestones would have been achieved (thereby entitling the MALT Trust to convert more of its restricted warrants into vested interests in Phoenicia) if all aviation-related businesses had been operated through Phoenicia exclusively, and (3) breach of a representation or warranty in Phoenicia’s operating agreement by failure to comply with the “purpose” clause in Phoenicia’s operating agreement.

The Court’s Decision

The court declined to dismiss the plaintiffs’ claim for breach of fiduciary duties. The plaintiffs argued that, by operating aviation-related businesses outside of Phoenicia, the defendants had usurped a business opportunity from Phoenicia in violation of its duties of loyalty. Under Delaware law, fiduciary duties can be waived in an operating agreement only through “plain and unambiguous” language. Language in the operating agreement made clear that Phoenicia’s managers were permitted to engage in other business activities outside of Phoenicia^[1]and that neither Phoenicia nor its members had any right to participate in such other business activities.^[2]However, the court found that these provisions did not unambiguously waive the defendants’ duty to present corporate opportunities to Phoenicia or other members of the company.^[3]

The court also declined to dismiss the plaintiffs’ claim that 777 Partners and Phoenicia breached the stock purchase agreement by failing to deliver some amount of the earnout interest to the MALT Trust. The MALT Trust would have received an additional equity stake if Phoenicia had met certain additional milestones, and the plaintiffs contended that those milestones would have been met if 777 Partners had operated its aviation-related businesses through Phoenicia exclusively. The court found that if the plaintiffs were to prevail on their claims that running the aviation-related businesses outside of Phoenicia breached the operating agreement’s implied covenant of good faith and fair dealing^[4]and the defendants’ fiduciary duties, then the plaintiffs may also prevail on their claims relating to the earnout interest. Of course, the plaintiffs would have a stronger position if they did not have to rely on the success of those other claims but, rather, could point to express earnout covenants in the stock purchase agreement that had been breached. If, as the plaintiffs contend, they had entered into the stock purchase agreement on the basis of the defendants’ oral representations in negotiations that 777 Partners would conduct all aviation business through Phoenicia, then this understanding should have been memorialized in a legally binding agreement.

Also of note, the court made clear that the purpose clause in the operating agreement^[5]did not constitute a representation or warranty obligating any party to limit its business activities outside of Phoenicia. The plaintiffs had argued that the purpose clause memorialized a commitment to operate  777 Partners’ aviation-related businesses through Phoenicia. The court disagreed, finding that the purpose clause merely established the scope of business activities in which Phoenicia was permitted to engage. In this way, a purpose clause should be viewed as defining the limitations (if any) on a company’s authority, rather than as creating an affirmative duty on any party to carry out any business activities falling within those limitations through the company.

Conclusion

At its core, MALT Family Trust v. 777 Partners LLC illustrates the importance of precision and comprehensiveness in contractual drafting. If parties intend to waive the right to be presented with corporate opportunities, this waiver must be clearly included in the applicable operating agreement. Buyers acquiring control of a company should be wary of creating “back doors” through which rollover sellers may claim the right to receive an otherwise unearned earnout. Likewise, sellers who are relying on various assumptions and expectations supporting their earnout prospects should take care to include appropriate covenants in the purchase agreement.

^[1]_{“No Manager shall be required to manage the Company as his or her sole and exclusive function, and may have other business interests and, except as otherwise expressly set forth herein or in any employment agreement between a Manager and the Company or an Affiliate thereof, if applicable, may engage in other activities in addition to those relating to the Company.” (Section 4.8 of the Operating Agreement)}

^[2]_{“Neither the Company nor any Member shall have any right, by virtue of this Agreement, to share or participate in such other investments or activities of the Managers or their Affiliates or to the income or proceeds derived therefrom.” (Section 4.8 of the Operating Agreement)}

^[3]_{Indeed, the operating agreement expressly provided that managers of Phoenicia owe fiduciary duties: “Notwithstanding the foregoing, nothing in this Section 4.8 or any other provision herein, shall limit, waive or otherwise amend the Managers’ fiduciary duty of care and loyalty to the Company and its Members pursuant to Section 18-1104 of the Act with respect to such other business interests and activities; and the Managers shall refrain from engaging in any activity which is inconsistent with their obligations thereunder.”}

^[4]_{The plaintiffs also alleged in a separate claim that certain defendants had breached their implied covenants of good faith and fair dealing under the operating agreement and stock purchase agreement by pursuing the aviation-related businesses outside of Phoenicia. This claim also survived the defendants’ motion to dismiss.}

^[5]_{The purpose clause reads as follows: “The purpose of the Company is to (i) engage in the business of acquiring and operating airlines and other related industries, providing services and creating, selling and licensing software for use in the airline and travel industries, and such other activities incident, necessary, advisable or desirable to carry out the foregoing  (the “Company Business”), and (ii) engage in any other lawful act or activity for which a limited liability company may be organized under the laws of the State of Delaware as determined by the Board from time to time.”}