Delaware Court Awards Lost Future Earnings to LLC Investors Because of Promoter's Fraud and Breaches of Fiduciary Duty
Many new businesses fail, for a variety of reasons, and that usually means the investors lose their investment. But it’s a bitter pill for the investors when the venture fails because of the promoter’s fraud and breaches of fiduciary duties. In a Delaware Court of Chancery case decided this week, the plaintiffs alleged fraud and breaches of fiduciary duty, and claimed that they had not only lost their investment, but also that their reputations were so besmirched by their involvement in the company’s fraudulent futures-trading scheme that they were effectively unemployable and were therefore entitled to damages for their lost future earnings. Paron Capital Mgmt., LLC v. Crombie, C.A. No. 6380-VCP (Del. Ch. May 22, 2012)(slip op.). The court agreed.
Background. Peter McConnon and Timothy Lyons met James Crombie in 2010. McConnon was a principal of a multi-billion dollar hedge fund based in London, and Lyons had worked as a senior investment professional for a number of financial institutions. Crombie had developed a software-based trading program in futures contracts, and explained that his trading program had annual returns of 25% in 2007 and 38% in 2008. He asserted that he had $30 million in assets under management, and invited McConnon and Lyons to join him in a new company to manage a hedge fund product and to trade futures on behalf of client accounts.
Due Diligence. Before deciding to join Crombie and form the new company, McConnon and Lyons conducted extensive due diligence on Crombie, his history, and his software product. They reviewed marketing materials from Crombie, including an independent verification from accounting firm Yulish & Associates, which certified that the returns claimed by Crombie were actual returns, verified through a third-party clearing broker. They checked references from 10 of Crombie’s former clients and colleagues, including mutual acquaintances. They interviewed Crombie in person and observed the software operate. They searched industry databases, interviewed Crombie’s lawyer about a lawsuit Crombie was involved in, and hired Kroll, Inc., an international risk consulting firm, to conduct a comprehensive background search on Crombie. None of those efforts turned up any red flags.
The New Company. Satisfied with their investigation, McConnon and Lyons entered into business with Crombie. They formed Paron Capital Management, LLC, a Delaware limited liability company, on June 2, 2010. Crombie had a 75% interest and was the initial manager, McConnon had a 20% interest, and Lyons a 5% interest. They commissioned an updated, independent verification of Crombie’s track record from Rothstein, Kass & Company, a national accounting firm, and used its report to begin marketing Paron to potential clients. Paron’s marketing materials were sent to over a hundred of McConnon’s and Lyons’ client contacts.
Fraud Revealed. On March 10, 2011, Paron received an audit request from its regulator, the National Futures Association (NFA). Numerous documents about Paron’s operations and Crombie’s predecessor company, JDC Ventures, LLC, were provided to the NFA. The NFA detected discrepancies and requested additional information. McConnon and Lyons began to investigate and learned that documents provided by Crombie to the NFA and to the accounting firm that had verified Crombie’s track record were false and had been forged by Crombie. After further investigation, McConnon and Lyons removed Crombie as a manager and member of the LLC, and the NFA issued a notice prohibiting Crombie and Paron from accessing, disbursing, or transferring any funds in Crombie’s name or a client’s name without prior NFA approval.
Lawsuits. On April 13 and 14, 2011, McConnon and Lyons filed two lawsuits against Crombie. Crombie entered into a stipulated judgment in the first lawsuit, in which he admitted that he was properly removed as a manager and member of the LLC, and agreed to a permanent injunction against using Paron assets or holding himself out as being affiliated with Paron.
In the second lawsuit, the plaintiffs sought damages for Crombie’s fraud and breach of fiduciary duty. A three-day trial was held in October 2011. Crombie failed to appear and presented no evidence, claiming financial hardship. Crombie filed for bankruptcy in February 2012, and the lawsuit was stayed. Later in February the stay was lifted.
Fraud. The court’s findings of Crombie’s fraud are damning. “[M]any of the representations Crombie made about his track record, employment history, and personal financial situation were outright lies.” Paron Capital Mgmt., slip op. at 10. Crombie forged account statements from multiple sources. Id. at 11. Crombie misrepresented his relationship with a prior employer and his personal financial situation. He failed to disclose another lawsuit against him and numerous personal debts he owed. The court found the plaintiffs’ reliance on Crombie’s representations to be justifiable, which isn’t surprising given their extensive due diligence.
Fiduciary Duties. The LLC’s operating agreement did not limit or exclude Crombie’s fiduciary duties as the manager, so Crombie owed the plaintiffs the traditional fiduciary duties of loyalty and care. Id. Those duties were breached both by Crombie’s preparation of fraudulent marketing materials for the LLC and by his continued concealment of material information about his track record, employment history, and personal finances. The court noted that under Delaware law, a fiduciary who remains silent about false, earlier communications that are relied upon by the beneficiary breaches his duty of loyalty. Id. at 16.
Damages. The court awarded McConnon reliance damages and mitigation costs totaling about $1.5 million. Those consisted of his loans and costs advanced to Crombie and to Paron in reliance on Crombie’s misrepresentations, and legal fees incurred in regulatory proceedings against Crombie and Paron and in foreclosing on collateral pledged by Crombie for the loan.
The vast majority of the damages claimed by McConnon and Lyons were for lost future earnings. “Specifically, Plaintiffs claim that their association with Crombie and Paron damaged their relationships with clients and effectively made them unemployable because they would be required to disclose their association with Paron to future employers, who, in turn, would have to disclose it to investors.” Id. at 20.
McConnon and Lyons provided trial testimony from two expert witnesses, an executive search professional with the financial services industry and a CPA certified in fraud examination and financial forensics. The executive recruiter testified that in his opinion, the clients he represents would not hire McConnon because of his association with Paron. The recruiter stated that his firm would be unwilling to even attempt to market McConnon because marketing an individual associated with fraudulent activity would hurt the recruiter’s business. The recruiter’s expert opinion was that McConnon would be unemployable in his field for the foreseeable future, other than for much lower-paying work only tangentially related to the capital markets.
Based on the recruiter’s expert opinions and on McConnon’s prior average annual earnings of more than $3.4 million, the CPA calculated McConnon’s lost future earnings over a 10-year period using two different methods, averaged the results, and estimated the lost earnings at $39.8 million. The court found the recruiter’s estimate of McConnon’s earnings if he had stayed at his prior firm to be overly optimistic, adjusted the amount downward, and awarded McConnon $32.2 million for lost future earnings.
Lyons’ compensation before leaving his prior employer was much lower, at about $200,000 per year. The executive recruiter and the CPA went through an analysis similar to their McConnon analysis, and after adjusting the CPA’s estimate, the court awarded Lyons $1.9 million for lost future earnings.
Comment. This case does not make new law, but it is a fascinating and odd case to consider. For one thing, the bad acts by the defendant were so egregious that the court’s legal conclusions of fraud and breach of fiduciary duty seem clear cut. Also, the fact that the defendant did not appear at trial would presumably undercut, at least to some degree, the precedential value of the court’s rulings.
The awards for the plaintiffs’ lost future earnings are unusual because they are based on injury to McConnon’s and Lyons’ reputations. Crombie’s fraudulent futures-trading scheme, and the involvement of McConnon and Lyons in Paron Capital Management, LLC, so tarred their reputations that they could no longer work in their former, highly paid capacities. And the facts showed that the effects on their careers would be long-lasting – up to ten years. (If Crombie had participated in the trial and presented experts with different opinions, the court might have reached different factual conclusions.) The long duration of the impact on the plaintiffs’ reputations, and in McConnon’s case the high level of his compensation prior to joining Crombie, led to a breathtakingly large ($32.2 million) award for McConnon.
The case is also a cautionary tale about due diligence. It’s hard to fault McConnon’s and Lyons’ investigation, as reported by the court, yet their due diligence completely failed. The court’s finding was that the plaintiffs acted reasonably in investigating Crombie. Id. at 15. Yet in hindsight, perhaps Crombie’s claim of consistent, high annual returns from his futures-trading program should have called for more probing of Crombie’s prior clients, and more double-checking of the authenticity of documents provided by Crombie.