Court of Chancery Affirms That Minority Stockholder May Be Controlling Stockholder

By David Forney and Eric Taylor

In Calesa Associates, L.P, et. al v. American Capital, Ltd., et. al, C.A. No. 10557-VCG (Del. Ch. February 29, 2016) (Glascock, V.C.), the Delaware Court of Chancery denied (with one minor exception) a 12(b)(6) motion to dismiss for failure to state a claim in a direct suit brought by stockholders of Halt Medical, Inc. (“Halt”) alleging breaches of fiduciary duties by an alleged controlling stockholder, American Capital, Ltd., a publicly traded private equity firm, and several of its affiliates (collectively, “American Capital”), and certain of Halt’s directors. The fiduciary duty claims relate to a recapitalization transaction (denominated by the Plaintiffs as a “squeeze-out merger”) that the plaintiffs claimed disproportionately benefitted American Capital and certain of Halt’s directors allegedly controlled by American Capital at the expense of Halt’s other stockholders.  The Plaintiffs argued that, through a complex series of premeditated transactions and control of Halt’s Board, American Capital chocked off Halt’s capital needs and then restructured Halt pursuant to a transaction resulting in a “squeeze out” of the minority stockholders.

The Court found that the plaintiff stockholders alleged facts sufficient to support a reasonable inference that American Capital was Halt’s controlling stockholder because of its control over the Halt Board, despite its 26% equity ownership stake. In reaching the decision, the Court reaffirmed that majority equity ownership is not the sole test, and that “control” exercised by a significant minority stockholder, even when the stockholder is exercising contractual blocking rights negotiated in prior equity transactions, is enough to characterize the non-majority stockholder as a controller for purposes of determining that the “entire fairness” standard, and not the business judgment rule, governs the board’s fiduciary duties and the controller’s actions.

The complaint stems from a complicated recapitalization transaction effected through a merger (the “Transaction”) that was put to Halt’s stockholders for a vote with no meaningful time for stockholders to consider the voluminous documentation involved. Halt’s financing history prior to the Transaction was turbulent, and American Capital had featured prominently both for the capital it did invest but also for the instances when it allegedly misled Halt into believing American Capital would supply additional capital only to retract such assurances. Prior to the Transaction, certain of Halt’s minority stockholders lent the company necessary funds when American Capital apparently would not, and repeatedly extended the maturity dates for the resulting bridge notes so that Halt could continue as a going concern.

In connection with its initial investment in Halt, American Capital was granted the right to appoint two of Halt’s five directors, as well as certain blocking rights with respect to subsequent equity transactions. In 2011, after the bridge financing provided by the minority stockholders, Halt obtained a third-party loan secured by its intellectual property. American Capital allegedly “secretly” purchased the resulting note and the secured interest. Later that year, American Capital blocked another third-party loan and allegedly forced Halt’s board to accept a $20M loan from American Capital at a 22% interest rate (the “Note”). In connection with the Note, American Capital was granted another seat on Halt’s board of directors.

Eventually, Halt owed American Capital $50M under the Note, which was scheduled to come due on December 31, 2013. Despite early indications that American Capital would extend the maturity date for the Note, in September 2013, American Capital demanded Halt re-pay Note in full at maturity, which Halt was incapable of doing.

American Capital’s demand caused Halt’s directors and its stockholders to assess various alternatives for the company’s continued existence. Halt’s board and American Capital eventually agreed on the Transaction, which is now challenged by the minority stockholders. In the Transaction, Halt formed a merger sub, merged with and into the merger sub, and all issued and outstanding shares of Halt’s preferred stock and warrants to purchase common or preferred stock of Halt were cancelled. The primary holders of the cancelled stock and warrants were Halt’s minority stockholders who had provided bridge financing. Halt’s common stock was unaffected by the Transaction. As part of the Transaction, American Capital also agreed to loan Halt an additional $73M in exchange for new shares of preferred and common stock. Additionally, a management incentive plan was adopted that provided for 12% of the proceeds of a liquidation transaction to be set aside for certain Halt executives, which primarily benefited Halt’s then-CEO who was also a director. Following the Transaction, American Capital held 66% of Halt’s outstanding stock and the right to designate four of Halt’s seven director positions.

The Transaction was rubber stamped by Halt’s board (which included three of seven members that were described in Halt’s information statement related to the Transaction as “affiliated” with American Capital). Halt’s stockholders were given one day to review almost 300 pages of documentation related to the Transaction and provide consent to such.

In determining whether American Capital was Halt’s controlling stockholder, despite its 26% ownership stake, the Court examined whether a majority of Halt’s board of directors was affiliated with or beholden to American Capital. Three of those directors were plainly affiliated, as disclosed in the documents related to the Transaction (American Capital tried to argue that one of the directors, who was an executive of one of its portfolio companies, was unaffiliated but the Court found the disclosure in Halt’s information statement was enough to establish a reasonable inference that such director was affiliated). The Court also found that the significant benefits afforded Halt’s CEO who was also a director (in addition to the management incentive pool, he was given a substantial raise, as was his assistant who received a raise in excess of $100,000) were enough to reasonably infer that the CEO was beholden to American Capital, since he could be terminated by American Capital.  Given that the plaintiff stockholders alleged facts sufficient to infer that at least four of Halt’s directors were beholden to American Capital, the Court held that sufficient facts were plead to show American Capital was Halt’s controlling stockholder and stood on both sides of the Transaction. Thus, American Capital would owe fiduciary duties to Halt’s stockholders directly and entire fairness would be the appropriate standard for review of the Transaction. The Court denied American Capital’s motion to dismiss for failure to state a claim, noting that the plaintiff stockholders had plead facts sufficient to support their claims for breaches of fiduciary duties by American Capital and its affiliated directors.

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