Duff v. Innovative Discovery LLC, C.A. No. 7599-VCP (Del. Ch. Dec. 7, 2012) (Parsons, V.C.)

In this memorandum opinion, the Delaware Court of Chancery denied motions to dismiss for lack of subject matter jurisdiction, failure to state a claim upon which relief could be granted, and improper venue. 

This action was filed against Innovative Discovery LLC, a Delaware limited liability company (the “Company”), by two of its former members, Edward Carp (“Carp”) and Bruce Duff (“Duff”), who sold their membership interests back to the Company under certain redemption agreements (the “Redemption Agreements”).  Pursuant to Section 8 of the Redemption Agreements (“Section 8”), the “total dollars . . . distributed or paid” by the Company to Duff and Carp for 2011 was to be $105,000 each, and the “total dollars . . . distributed or paid” to Duff and Carp for 2012 was to be $0 each.  Carp and Duff alleged that in the course of negotiating the Redemption Agreements, the parties involved understood Section 8 to cap taxable income at the said amounts for 2011 and 2012.  Ultimately, however, the Company issued 2011 Schedule K-1s to Carp and Duff that allocated $231,354 in taxable income to each of them, and caused Carp and Duff to each have higher tax liability than expected.  Carp accused the Company of violating Section 8.

Thereafter, Carp, Duff and Delaware Document Imaging, LLC (“DDI” and collectively with Carp and Duff, the “Plaintiffs”) filed a Complaint against the Company asserting claims for: (1) breach of the Redemption Agreements; (2) an accounting; (3) a declaratory judgment with respect to Carp’s and Duff’s rights under the Redemption Agreements; (4) breach of a certain license agreement (the “License Agreement”) between DDI and the Company; and (5) breach of certain consulting agreements (the “Consulting Agreements”) between Carp and Duff and the Company.  In response, the Company moved to dismiss all five counts for lack of subject matter jurisdiction, Counts 1 through 3 for failure to state a claim upon which relief could be granted, and Count 4 for improper venue.

The Court first denied the Company’s motion to dismiss for lack of subject matter jurisdiction.  According to the Vice Chancellor, the Court of Chancery can acquire subject matter jurisdiction over a case by three different means: (i) the invocation of an equitable right; (ii) a request for an equitable remedy when there is no adequate remedy at law; or (iii) a statutory delegation of subject matter jurisdiction.  The Plaintiffs argued that the Court had jurisdiction under Section 18-111 of the Delaware Limited Liability Company Act (“the Act”), which states, in pertinent part, that “[a]ny action to interpret, apply or enforce . . . the duties, obligations or liabilities of a limited liability company to the members or managers of the limited liability company . . . or any other instrument, document, agreement or certificate contemplated by any provision of this chapter, may be brought in the Court of Chancery.”

The Plaintiffs argued that Count 1 fell within multiple clauses of Section 18-111.  First, according to the Plaintiffs, Count 1 qualified as an action to enforce the “duties, obligations or liabilities of a limited liability company to [its] members.”  Second, the Plaintiffs argued that seeking enforcement of the Redemption Agreements constituted an action to enforce “any instrument, document, agreement or certificate contemplated by any provision of [the Act].”  The Redemption Agreements, according to the Plaintiffs, were contemplated for in Section 18-702 of the Act, which states that “a limited liability company may acquire, by purchase, redemption or otherwise, any limited liability company interest or other interest of a member or manager in the limited liability company.”  The Court of Chancery agreed with the Plaintiffs on both arguments and found that it had subject matter jurisdiction over Count 1.  In agreeing with the Plaintiffs, the Court rejected the Company’s arguments that (i) Section 18-111 required the Court to have an independent basis for exercising its equitable jurisdiction, and (ii) the Court had discretion to refuse to hear the Plaintiffs’ claims once the Plaintiffs brought the claims in the Court of Chancery. 

Under the cleanup doctrine, the Court also found that it had subject matter jurisdiction over the remaining counts.  The Court stated that the cleanup doctrine could be used to obtain jurisdiction over the remaining counts for any of several reasons, including, promoting judicial efficiency.  Here, because Count 1 was closely intertwined with the Plaintiffs’ claims for an accounting, declaratory judgment, breach of the License Agreement, and breach of the Consulting Agreements, the Court held that severing the claims would undermine judicial efficiency.  Thus, the Court exercised subject matter jurisdiction over all five counts.

The Court then denied the Company’s motion to dismiss Counts 1 through 3 for failure to state a claim upon which relief could be granted.  According to the Court, the Complaint alleged sufficient facts to support a claim for mutual mistake at the pleading stage, and because reformation of a contract is a well-recognized remedy for mutual mistake as to a term of a contract, the Plaintiffs stated a claim for reformation.

Lastly, the Court denied the Company’s motion to dismiss Count 4 for improper venue.  The Company argued that California was the proper venue for Count 4 because the License Agreement’s forum selection clause provided that the “sole jurisdiction and venue for actions related to the subject matter [thereof] shall be the state and U.S. federal courts located in California.”  The Redemption Agreements, however, provided for a Delaware venue and incorporated the License Agreement by reference.  Under Delaware law, where a contract incorporates another contract by reference, the two contracts shall be read together as a single contract.  Further, a forum selection clause is “strictly binding” only when the parties to the agreement use “express language clearly indicating that the forum selection clause excludes all other courts before which those parties could otherwise properly bring an action.”  Because of the conflicting forum selection clauses in the License Agreement and Redemption Agreements, California was not the exclusive forum for a claim for breach of the License Agreement.  Thus, the Court denied the Company’s motion to dismiss for improper venue.

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