Chancery Court Determines Appropriate Standard of Review for Cash Flow “Tunneling” by Controlling Stockholder

By David Forney and Eric Taylor

In In Re EZCorp Inc. Consulting Agreement Derivative Litigation, C.A. No. 9962-VCL (Del. Ch. January 25, 2016) (Laster, V.C.) the Delaware Court of Chancery granted in part and denied in part a 12(b)(6) motion to dismiss for failure to state a claim, but at its heart the ruling addressed the proper standard of review in a case alleging self-dealing by a controlling stockholder for “tunneling” cash flow and receiving non-ratable benefits from related-party services agreements. After a detailed and extensive analysis, the court held that the entire fairness standard of review, and not the business judgment standard of review, applied to non-merger business transactions where controlling stockholders can exact non-ratable benefits from the company, regardless of the type of transaction or method of extraction.

The action arose when a stockholder brought a derivative suit on behalf of nominal defendant EZCorp, Inc., a Delaware public company (“EZCorp”), in the business of providing instant cash solutions including pawn loans and other short term loans, challenging the fairness of several related-party consulting agreements between EZCorp and entities owned by its controlling stockholder, Phillip Ean Cohen (“Cohen”). The complaint alleges that the audit committee of EZCorp’s board of directors breached its fiduciary duties by rubber-stamping annual consulting agreements between Madison Park, LLC, a Cohen affiliate (“Madison Park”), and EZCorp. The consulting agreements provided for rapidly escalating year-over-year fees payable to Madison Park in exchange for advisory services on business and long-term strategic planning. The complaint alleges that the directors approved the consulting agreements without question because of their positions with Cohen entities. The complaint also alleges that Cohen aided and abetted the audit committee’s breaches, though the Court found sufficient facts alleged to infer a complaint against Cohen directly for breach of fiduciary duty of loyalty for sitting on both sides of the challenged transactions.

The complaint challenges agreements between Madison Park and EZCorp for the years 2011-13 (the “Challenged Agreements”). The 2011 Agreement called for annual fees of $6M, which amounted to 5% of EZCorp’s net income for the year. By 2013, the agreement between Madison Park and EZCorp called for annual fees of $7.2M, but a dip in EZCorp’s revenues meant that such fees amounted to 21% of EZCorp’s net income. The complaint alleges that the Challenged Agreements were not legitimate contracts for services, but rather a means by which Cohen extracted a non-ratable return from EZCorp. The complaint alleges that, during the periods covered by the Challenged Agreements, EZCorp had an experienced and highly compensated team of senior managers whose jobs included the very services purported to be provided by Madison Park, itself a small entity with limited resources and EZCorp as its only publicly traded client.

EZCorp has a dual-class structure: Class A non-voting common stock, which is publicly traded, and Class B voting common stock, representing approximately 5% of the outstanding stock of EZCorp and is 100% owned by MS Pawn L.P. (which is ultimately controlled by Cohen). Through this mechanism, Cohen controls 100% of the vote of EZCorp and has the power to remove board members at his choosing. The complaint alleges that such control caused the members of EZCorp’s audit committee to approve the Challenged Agreements without serious consideration because the board members feared they would be removed from their positions if they did not approve the Challenged Agreements. (Each director on the audit committee was paid more than $200,000 annually for their service, in addition to each being paid directors for other entities controlled by Cohen.) Indeed, the directors’ fears may have been well grounded–in May 2014, EZCorp’s audit committee terminated the 2013 consulting agreement with Madison Park and Cohen promptly removed two directors on the audit committee and EZCorp’s CEO, replacing them with more friendly faces.

The Court’s ruling first addresses the proper defendants, holding that there were sufficient facts plead to infer a direct claim against Cohen, as noted above. The Court then addressed the applicable standard of review. The defendants had argued that the business judgment rule should apply, because the entire fairness standard should only apply to squeeze-out mergers. Here, the defendants argued, the corporation engaged in a standard business transaction with a related-party and the directors should be afforded business judgment review. Supporting this proposition, the defendants cited three cases that purported to support this reading. The Court, alternatively, cited many varied precedents supporting the notion that entire fairness review should apply any time a controlling stockholder stands on both sides of a challenged transaction. The Court went to great lengths reviewing the precedents raised by the defendants, noting that “there is considerable tension in [the] lines of authority” before ultimately concluding that the weight of authority, and the rationale behind the authority, supported the proposition that entire fairness review should apply any time controllers can exact non-ratable benefits, regardless of the type of transaction or method of extraction. To hold otherwise, the Court noted, would encourage controlling stockholders to choose one method of non-ratable extraction over another.

The Court reviewed the facts plead by the plaintiff stockholder under the entire fairness standard of review and noted that the complaint supports a reasonable inference that the Challenged Agreements were not entirely fair. The Court described several factors that led to its decision, including the fact that the capital structure of EZCorp created a disincentive for paying dividends and a strong incentive for Cohen’s obtaining returns through direct transfers, the amount and timing of the payments to Madison Park, the minimal resources of Madison Park and its lack of any other publicly traded clients, the duplication of services between Madison Park and EZCorp’s executive team, the audit committee’s eventual decision to cancel the last of the Challenged Agreements, and Cohen’s subsequent retaliation against two members of that committee for such cancellation. At the pleading stage, the foregoing facts were enough to survive a 12(b)(6) motion to dismiss for failure to state a claim, especially when judged by the entire fairness standard.

The complaint also alleged claims for waste and aiding and abetting the directors’ breach of fiduciary duties, which the Court ruled to survive the pleading stage despite noting that both claims were likely secondary to the principal claims for breach of fiduciary duties. The complaint last alleged a claim for unjust enrichment, which the Court dismissed because it was ultimately duplicative and unnecessary. The defendants also sought to have the complaint dismissed under Rule 23.1 for failure to plead demand excusal. The Court noted that a stockholder having a viable derivative claim does not necessarily mean that he can assert it, rather Delaware law requires a demand to the company’s board of directors or a showing as to why such demand would be futile. In order to show that a demand would have been futile, there must be “reasonable doubt” as to the independence of the board of directors. Given the cushy arrangements with Cohen’s directors, and Cohen’s apparent hand-picking of directors who would go along with his wishes, the Court found that there was reasonable doubt as to the independence of more than half of EZCorp’s directors and, therefore, a demand would have been futile in this case.


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