Fiduciaries, Be Warned: The Court of Appeal awards significant monetary damages against former tech founders and their investors

December 13, 2021

The Ontario Court of Appeal recently released an important decision involving two former tech co-founders and an ex-Facebook executive who were found to have committed breaches of fiduciary duty, breach of contract, conspiracy, and other torts in respect of the establishment of a competing business and the sale of a software development company: Extreme Venture Partners Fund I LP v. Varma, 2021 ONCA 853.

There are many key takeaways from the Court of Appeal’s decision, which, as the Court itself noted: “…[raises] important issues about remedies and, more fundamentally, acceptable standards of conduct in corporate Canada.” It is abundantly clear that this case is intended to serve a strong rebuke of the conduct of the Appellants, and it should serve as a warning for senior executives and other fiduciaries who seek to compete with their former employers.

The Facts

The Appellant Corporation, Extreme Venture Partners Fund I LP (“Fund I”), is a venture capital fund that provides seed capital to start-up technology companies. Fund I was founded by the various Respondents (Sharma, Bashir, and Teslia) and the two of the Appellants (Varma and Madra, or the “Varma/Madra Appellants”).

At trial, the Respondents asserted two key claims:

The “Annex Fund Claim,” alleging that the Varma/Madra Appellants were liable for breach of fiduciary duty and breach of contract regarding the establishment of a competing business; and
The “Xtreme Labs Claim,” alleging that the Varma/Madra Appellants were liable for breach of fiduciary duty, breach of contract, and conspiracy and that the Palihapitiya Appellants were liable in tort for knowing assistance in breach of fiduciary duty, inducing breach of contract, and conspiracy, all concerning the sale of Xtreme Labs Inc. (“Xtreme Labs”).

Annex Fund Claim

The Respondents’ first key claim was related to Varma and Madra’s establishment of a competing business. While Fund I had grown rapidly and achieved financial success, by late 2010 tensions had started to develop between Sharma, Bashir and Teslia on the one hand and Varma and Madra on the other. Varma and Madra testified at trial that they were doing all the work to grow the businesses and were not being adequately recognized or compensated for their efforts. As a result (and, ultimately, to their detriment), they began seeking out other opportunities.

Specifically, Madra began talking about establishing a competitive fund with another global private markets investment firm (“Northleaf”) acting as the primary limited partner. Eventually, Varma joined these conversations and Varma and Madra established a second fund, namely the Appellant, Extreme Venture Partners Annex Fund I LP (the “Annex Fund”). Varma and Madra concealed the existence of the Annex Fund from their other partners, and also provided Northleaf with confidential information about Fund I’s portfolio and investment strategy. The Annex Fund invested in six of Fund I’s most successful portfolio companies and operated for two years until it closed in 2013.

Xtreme Labs Claim

The other key claim asserted by the Respondents was related to a conspiracy between a number of the Appellants in respect of the sale of Xtreme Labs, a mobile software development lab business co-founded by Madra and Varma.

In or around 2011, the parties had started to explore options to sell Xtreme Labs. At the time, the equity in Xtreme Labs was primarily split equally amongst Sharma, Bashir, Teslia, and holding companies owned by Varma and Madra. Madra and Varma presented projections which suggested that the company’s growth would slow, which disappointed the other members of the Board. The initial efforts to sell Xtreme Labs were unsuccessful, and the Board members had different opinions about the company’s value. Unbeknownst to the other Board members at the time, Madra had already been in contact with the Respondent, Palihapitiya, to discuss the sale of Xtreme Labs. Palihapitiya was a prominent Silicon Valley entrepreneur, a founding senior executive at Facebook, and good friend of Varma and Madra’s. Together, the parties conspired to prepare an offer by Palihapitiya to purchase Xtreme Labs which would also allow Varma and Madra to stay on with the company after the sale.

The offer was provided to the Board, but Varma and Madra did not disclose to the Board that they had been involved in its preparation. The trial judge found that Varma and Madra worked with Palihapitiya to facilitate his acquisition of Xtreme Labs at a discounted purchase price by: (a) understating the company’s revenue projections; (b) advancing a low earnings multiple; and (c) concealing the company’s equity interest in Hatch Labs, a company that had developed the mobile dating app Tinder. Prior to the sale, Palihapitiya, Varma, and Madra also carved certain assets out of Xtreme Labs (including Hatch Labs) and transferred them to a holding company of which they were the sole shareholders. Following the sale, the holding company owned by the Appellants sold its stake in Hatch Labs to a large American corporation for $30 million US.

The Trial Decision

At trial, Justice Conway accepted the Respondents’ version of events in respect of the Annex Fund Claim and held that that Varma and Madra had breached their duties of honesty, loyalty, and confidentiality owed by virtue of being directors of EVP GP. However, she dismissed the Respondents’ passing off claim. While the Respondents alleged reputational damages and sought compensatory damages for lost opportunities in respect of the Annex Fund Claim, Justice Conway ruled such damages were not made out. However, she found that an award of significant punitive damages in the sum of $250,000 was appropriate.

In respect of the Xtreme Labs Claim, Justice Conway held that the Appellants coordinated their efforts to present Palihapitiya’s offer to buy the company at the board meeting in March 2012. Further, Varma and Madra hid this coordination and pressured the board to accept the offer in order to: (a) increase their compensation and equity in the business; and (b) facilitate Palihapitiya’s acquisition of Xtreme Labs at a discounted purchase price. As such, she found that the Palihapitiya Appellants and the Varma/Madra Appellants were jointly and severally liable for $3.36 million (U.S.) in damages and $12.33 million (U.S.) in disgorgement of profits. She also made additional orders regarding the applicable exchange rate and prejudgment interest.

The Appeal

On appeal, the two groups of Appellants took different approaches. Namely:

The Varma/Madra Appellants did not challenge the factual findings made by the trial judge. Instead, they alleged a number of errors in law that boil down to: (a) the calculation of damages in the sale of Xtreme Labs; and (b) the validity of an amendment to the Statement of Claim to seek disgorgement regarding the sale of Hatch Labs.
The Palihapitiya Appellants adopted the legal arguments advanced by the Varma/Madra Appellants, but also argued that a knowing assistant should not face the same liability as a faithless fiduciary. The Palihapitiya Appellants also alleged that the trial judge had made various errors of fact in her decision. Of particular note is their submission to the Court of Appeal that “…their conduct was well within the boundaries of ethical and legal corporate behaviour and that the trial judge’s findings of misconduct are based on her own “idiosyncratic moral values.”

The Respondents made a cross-appeal which argued that the trial judge was correct in making an order for disgorgement of profits in respect of the Xtreme Labs Claim, but that the damages award will have no deterrent effect because the Appellants are obliged to disgorge to the Respondents only what they would otherwise be entitled to receive had they not breached their fiduciary duty.

The Court of Appeal dismissed the appeals of the Appellants and allowed the cross-appeal of the Respondents, increasing the disgorgement of profits order to $29.5 million US. While this article will not detail all of the legal and factual findings made by the Court, the following findings are worthy of note:

The Court rejected the arguments made by the Varma/Madra Appellants that the damages award on the sale of Xtreme Labs “lacked an evidentiary foundation.” In doing so, the Court found that Justice Conway reasonably calculated the damages award because it aimed to put Respondents in the correct position they would have otherwise been in had they been given correct information regarding the revenues of Xtreme Labs.
The Court also rejected the argument advanced by the Varma/Madra Appellants that the trial judge had erred in ignoring the lack of evidence of a potential buyer of Xtreme Labs at a higher price. Specifically, the Court commented that the Appellants ignored the fact that their own misconduct had prevented Xtreme Labs from being properly marketed because they had concealed the underlying revenue of the company and thus it could not be properly presented to potential buyers. The Court also agreed with Justice Conway’s finding that, due to the conduct of the Appellants, the Respondents were deprived of the opportunity to sell the Company or retain their shares and sell at a much higher value later.
The Appellants submitted that, among other things, Justice Conway erred in not requiring a causal relationship between the wrongdoing and the profits to be disgorged. Specifically, they argued that the profits from the sale of the equity of Hatch Labs were not causally connected to the wrongful conduct, because the increase in value was only due to Tinder’s popularity at 2014 Sochi Olympics and no one could have predicted at the time of sale that Tinder would be such a success. The Court of Appeal rejected this argument, finding that fiduciaries have a duty to disclose to the Board all of the information with respect to a company’s assets (regardless of whether or not they thought it had the potential for future success) so that the Board may have the opportunity to make an informed decision.
The Court was particularly critical of the legal position asserted by the Palihapitiya Appellants, namely that their conduct was legal and consistent with Canadian business conduct standards and that Justice Conway had “inappropriately falsified her idiosyncratic moral values and thereby found wrongdoing where there was none.” The Court firmly rejected these arguments, calling them a “straw man argument” and noting that that Justice Conway had properly applied the settled law of corporations, fiduciary duty, contract, and tort to the conduct of the Appellants. In doing so, the Court specifically noted that the testimony of the Palihapitiya Appellants was contradicted time and time again by the written record, and found there was ample evidence that they conspired with the Varma/Madra Appellants to mislead the Board about equity interest in Hatch Labs and the development of the Tinder app. It is clear that the Court did not look too kindly upon the Appellants’ conduct vis a vis the Respondents, and their decision strongly suggests that similar conduct could expose parties in future litigation to significant legal and financial repercussions.

Key Takeaways:

The Court of Appeal’s recent decision in Extreme Ventures is significant for the following reasons:

It confirms already established principles that senior executives will be held to a high legal standard in respect of their fiduciary obligations; and
It serves as a clear warning to senior executives who seek to compete with their former employer, as they may be exposing themselves (and their potential investors or new employers) to significant monetary damages and disgorgement of profits.