Chancery Court Finds That Stockholders Have Standing For Direct Suit Relating To Unique Claims For Breach Of Fiduciary Duties
By: David L. Forney and Calvin D. Kennedy
In In re Straight Path Communications Inc. Consol. S’holder Litig., C.A. No. 2017-0486-SG (Del. Ch. June 25, 2018), the Court of Chancery, denied a motion to dismiss, finding that the transfer of an indemnification claim to the controller of a company was “sufficiently intertwined” with the company’s sale for the stockholders to make the Plaintiff’s claim a direct claim instead of a derivative claim. The Court stated that when a controller uses his control to extract a special benefit in a sale, at the expense of the consideration to the stockholders, both the injury and the recovery run directly in favor of the former stockholders. The Court also found that, the controller’s actions related to the purchase of the indemnification claim and other assets from the company for “a manifestly unfair price” were sufficient to state a viable claim for breach of fiduciary duties.
In 2013, IDT Corporation (“IDT”) spun off its subsidiary, Straight Path Communications Inc. (“Straight Path”), and distributed Straight Path common stock to IDT stockholders. As part of the spinoff, the companies entered into a Separation and Distribution Agreement which required IDT to indemnify Straight Path for any liabilities related to the pre-spinoff period. Subsequent to the spinoff, the Federal Communications Commission (“FCC”) began investigating IDT for certain pre-spinoff compliance issues (the “Indemnification Claim”). In early 2017, Straight Path entered into a Consent Decree with the FCC which left Straight Path with “no practical choice but to sell itself” and IDT recognized that it could face liability through its indemnification obligations to Straight Path. Straight Path then began to pursue a sale and formed a special committee of the board of directors to evaluate sale options (the “Special Committee”). The Special Committee decided to “preserve and pursue the [I]ndemnification [C]laim for the benefit of Straight Path’s stockholders” and started to plan the establishment of a litigation trust through which the Indemnification Claim could be pursued after the sale.
Howard Jonas (“Howard”), founder and chairman of IDT and Straight Path’s controlling stockholder, did not want the Indemnification Claim to survive the sale because a successful pursuit of the Indemnification Claim could bankrupt IDT. Howard, whose consent was necessary as Straight Path’s controlling stockholder, threatened to “blow up the sales process” if the Special Committee moved forward with preserving the Indemnification Claim. Due to Howard’s threats, the Special Committee signed a term sheet which would settle the Indemnification Claim and sell certain assets to IDT for a total of $16 million. Subsequently, Verizon entered into a merger agreement with Straight Path at a total enterprise value of $3.1 billion which resulted in the FCC being paid $614 million in accordance with the Consent Decree.
JDS1 and The Arbitrage Fund, common stockholders of Straight Path (the “Plaintiffs”), filed a class-action complaint, containing four counts, directly challenging the Verizon merger. Count I alleged that Howard breached his fiduciary duties as Straight path’s controlling stockholder by “using his position… to extract unique benefits from the sales process, to the detriment of the company’s minority stockholders.” Count II alleged that Davidi Jonas (“Davidi”), Howard’s son and Straight Path’s CEO, breached his fiduciary duties by providing confidential information to his father. Count III alleged that IDT aided and abetted the above breaches.
The defendants, including Straight Path, IDT, Howard and Davidi, moved to dismiss and argued that the Plaintiffs’ claims were “derivative rather than direct, and that the derivative claims fail as a matter of law.” In order to determine whether the claims were direct or derivative, the Court considered “(1) who suffered the alleged harm (the corporation or the suing stockholders, individually); and (2) who would receive the benefit of any recovery or other remedy (the corporation or the stockholders, individually).” The Court determined that the allegations supported a reasonable inference that the stockholders, individually, had (1) suffered the alleged harm and (2) would receive the benefit of any recovery or remedy as Howard’s threats to the Special Committee “improperly diverted the merger consideration that otherwise would have gone to the stockholders.” Thus, the Straight Path stockholders “ended up receiving hundreds of millions of dollars less in merger consideration than they would have but for Howard’s disloyalty.” Therefore, the Court found that the Plaintiffs stated direct claims and that the Plaintiffs’ standing was not extinguished by the Verizon merger.
With respect to Count I, the Court, applying an entire fairness review, found that the Plaintiffs stated viable claims against Howard because he acted disloyal when he “conditioned his support for the merger on receiving unique, non-ratable benefits at the expense of the company’s minority stockholders” and threatened the Special Committee in order to extract such benefits. Similarly, with respect to Count II, the Court found that the Plaintiffs adequately alleged that Davidi had breached his fiduciary duties by acting disloyal to Straight Path when he supplied confidential information to Howard. Lastly, because the defendants’ sole argument for dismissing Count III was that neither Howard nor Davidi had breached their fiduciary duty, the Court found that Count III also survived based on the Court finding that Count I and Count II were adequately alleged.