Zutrau v. Jansing, C.A. No. 7457-VCP (Del. Ch. July 31, 2014) (Parsons, V.C.)
By David Bernstein and Meredith Laitner
On July 31, 2014, the Delaware Chancery Court issued its decision in Zutrau v. Jansing, C.A. No. 7457-VCP (Del. Ch. July 31, 2014) (Parsons, V.C.), requiring the parties to recalculate the payment to which the plaintiff was entitled because her 22% minority interest in a Delaware corporation was squeezed out through a reverse split that reduced her holding to less than one full share. The plaintiff in this case, a former employee of Ice Systems, Inc., brought a derivative suit in which she challenged numerous business decisions made by Ice Systems after her employment terminated and challenged compensation and expense reimbursement payments made to the CEO, who was also the 78% stockholder and the sole director. The plaintiff also (a) asked the Court to set aside the reverse split on the ground that it was made for the improper purpose of depriving her of the ability to bring a derivative suit, or alternatively (b) to increase the sum to which she was entitled as a result of the cancellation of her 22% interest through the reverse split.
The Court did not decide whether the plaintiff no longer had standing to sue derivatively because she was no longer a stockholder when she commenced the suit, because the defendant acknowledged that if Ice Systems would have been entitled to recover sums if the plaintiff had been able to sue derivatively, the corporation’s right to recover those sums would increase the amount to which the plaintiff is entitled because of the cancellation of her stock interest, and therefore, the outcome of her suit would be the same whether or not she was permitted to sue derivatively.
The Court denied all the challenges to business decisions made by Ice Systems, finding them all protected by the business judgment rule. However, it ruled that the issues regarding the compensation and reimbursement of expenses of the defendant (the CEO/78% stockholder) were subject to the entire fairness test and found the compensation to have been excessive and a small amount of reimbursed expenses having been personal, not business related. In reaching that decision, Vice Chancellor Parsons held that the process by which the defendant’s bonuses were determined — unilateral decisions by the defendant as the sole director of the corporation, did not satisfy the requirement of a fair process, and that the amount of the bonuses exceeded fair compensation. As a result, Vice Chancellor Parsons ruled that the amount of the excess compensation and of the personal expenses should be included in an assessment of the total value of Ice Systems at the time of the minority stockholder squeeze out.
With regard to the reverse stock split, the Court said that it was permitted by a provision of the Delaware General Corporation Law that expressly permits a Delaware corporation to cash out a stockholder that, as a result of a reverse split, holds a fraction of a share — even if the purpose of the reverse stock split was to eliminate that stockholder. However, Vice Chancellor Parsons said that, even though the amount to be paid to the squeezed out minority stockholder was based on a valuation by Duff & Phelps that was properly made on the basis of historical information about the corporation’s cash flows, the valuation would have been higher if it had been based on the higher cash flows that would have been achieved if the CEO had not received excess compensation or been reimbursed by the corporation for some personal expenses. Vice Chancellor Parsons therefore directed the parties to recalculate the fair value of the plaintiff’s stock interest in Ice Systems when the reverse split took place, (a) taking into account the higher cash flows that would have been achieved if the CEO had not received excess compensation and reimbursement for personal expenses, and (b) increasing the value of the corporation by the amount it would have been entitled to receive from the defendant as a return of the excess compensation and reimbursement for personal expenses.