August 20, 2019

Tenth Circuit: Managers Acted in Bad Faith by Painting Grim Financial Picture to Valuation Firms

The Tenth Circuit Court of Appeals issued its opinion in Leone v. Owsley on Wednesday, November 25, 2015.

Charles Leone was a principal of Madison Street Partners, LLP (MSP). In 2012, he resigned his position, and fellow principals Stephen Owsley and Drew Hayworth (Managers) elected to buy Leone’s interest in MSP. The Operating Agreement required the purchase price to be set at fair market value, and the Managers received two independent valuations from St. Charles Capital, LLC, and INTRINSIC. Although it was not used in calculating the offer to Leone, in 2009 Duff & Phelps had valued MSP at between $50 and 65 million. The Managers reluctantly gave the Duff & Phelps report to St. Charles and INTRINSIC, but urged them to ignore it, arguing it was not relevant. The Managers characterized MSP as having poor performance and did not give the valuation firms MSP’s newsletters or other relevant information.

St. Charles valued MSP with a total 2011 revenue of $5.892 million and total net income of $2.21 million. MSPs internal profit and loss statement listed total 2011 revenue as $7.289 million and net income of $3.398 income. INTRINSIC prepared a less detailed report without an opinion as to MSP’s value. Based on the two reports, the Managers offered Leone a purchase price of $135,850. Leone rejected the offer and retained his own expert to value his interest. Leone’s expert calculated his interest as of August 2012 at $1.5 million. Around the same time, Owsley sent his father an email expressing an interest in buying out Leone, remarking that MSP was stable.

In November 2012, Leone brought suit against the managers in the U.S. District Court for the District of Colorado, alleging that they had breached Article 10, Section 10.2(d) of the Operating Agreement by failing to act in good faith in valuing his interest in MSP. Leone also argued the Managers breached the implied covenant of good faith by unreasonably attempting to force him to sell his interest for a price far below fair market value. Managers claimed Leone’s claims were barred because of their “good faith reliance on the advice of one or more third parties.” They moved for summary judgment, and the district court granted their motion. The district court ruled that the valuation firms were qualified to provide expert reports and there was no evidence Managers relied blindly on the reports. As to Leone’s claim that the Managers improperly influenced the valuation firms in order to receive more favorable numbers, the district court found that he had failed to raise a dispute of material fact about the procedural integrity of the valuation.

On appeal, Leone argued that the district court erred in its interpretation of Delaware law by (1) conflating express and implied contractual obligations of good faith, (2) holding that bad faith requires a tortious state of mind, and (3) refusing to consider the substantive unreasonableness of the offered purchase price. He also argued that the district court erred in granting summary judgment because he raised genuine issues of material fact. The Tenth Circuit first evaluated Leone’s argument that the district court erred in conflating express and implied bad faith. The Tenth Circuit noted that under either standard, a good faith evaluation of the ownership interests would require the Managers to refrain from taking action that would result in a lower valuation.

The Tenth Circuit next addressed Leone’s contention that the district court erred in finding that a tortious state of mind is required for bad faith. Analyzing the district court’s opinion as a whole, the Tenth Circuit found it properly stated the Delaware requirements for bad faith. The Tenth Circuit next addressed Leone’s argument that Delaware’s safe harbor provision does not immunize the Managers because they acted in bad faith by wrongfully influencing the valuation firms and relying on valuation figures that were clearly erroneous. The district court concluded it should refrain from considering the substantive accuracy of the valuation reports absence a finding of wrongdoing, then held that no reasonable juror could find that the Managers did anything that affected the procedural integrity of the valuation. The Tenth Circuit disagreed with the district court’s conclusion, noting that when taken in the light most favorable to Leone, a reasonable jury could conclude that the Managers did not rely in good faith on the valuation firms.

Addressing Leone’s claim that the district court erred in granting summary judgment, the Tenth Circuit agreed. Considering the evidence in the light most favorable to Leone, the Tenth Circuit found the district court erred in rejecting that an inference of bad faith could be drawn by the Managers’ actions. The Tenth Circuit noted that a reasonable jury could find that the Managers engaged in conscious wrongdoing based on inaccurate statements to the valuation firms. The Tenth Circuit noted that a reasonable jury could disagree with the district court’s conclusion that the Managers’ false statements did not materially influence the valuation firms’ reports.

The Tenth Circuit reversed the district court’s grant of summary judgment and remanded for further proceedings.

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