By Whitney J. Smith and Mehreen Ahmed
In Gary D. Voigt v. James S. Metcalf et. al. and NCI Building Systems, Inc., C.A. No. 2018-0828-JTL (Del Ch. Feb. 10, 2020), the court denied defendants’ motion to dismiss, finding that the transaction at issue should be reviewed under the entire fairness standard and that the plaintiff, a stockholder of NCI Building Systems, Inc. (“NCI”), successfully stated claims for breach of fiduciary duty and unjust enrichment against private equity firm Clayton, Dubilier, & Rice (“CD&R”) and most of NCI’s directors in connection with a stock-for-stock merger between NCI and Ply Gem Parent, LLC (“Ply Gem”). The headline issue for the motion to dismiss was whether the plaintiff had pled facts that made it reasonably conceivable that CD&R controlled NCI despite owning less than a majority of NCI’s outstanding shares.
In April 2018, CD&R acquired a controlling ownership interest in Ply Gem by completing a leveraged buyout of its publicly traded predecessor, Ply Gen Holdings Inc. (“Old Ply Gem”), and then combining Old Ply Gem with Atrium, a portfolio company owned by Golden Gate Capital (the “Precedent Transaction”). When negotiating the Precedent Transaction, CD&R and Golden Gate agreed to value Old Ply Gem’s equity at $425.2 million and Atrium’s equity at $212.8 million, for an agreed-upon post-transaction equity value of $638 million. After the Precedent Transaction, CD&R owned 70% of Ply Gem and had the right to appoint a majority of its directors.
Separately, CD&R owned a 34.8% ownership interest of NCI’s voting shares. Three months after the closing of the Precedent Transaction, NCI entered into a stock-for-stock merger agreement with Ply Gem in which NCI would be the surviving corporation and NCI’s stockholders would receive 53% of the post-transaction equity and Ply Gem’s stockholders would receive 47%. The split valued Ply Gem’s equity at $1.236 billion, a 94% premium over the value established by the Precedent Transaction three months earlier. Interestingly, the merger between NCI and Ply Gem was approved by 55% of NCI’s stockholders who were not affiliated with CD&R, but the merger was not conditioned on a majority-of-the-minority vote.
The plaintiff filed suit in November 2018 asserting three causes of action — Count I: breach of fiduciary duty against CD&R, Count II: breach of fiduciary duty against NCI’s directors, and Count III: unjust enrichment against CD&R. The plaintiff maintained that CD&R controlled both NCI and Ply Gem, and therefore CD&R and the directors must establish that the merger was entirely fair. The plaintiff alleged that the merger was not entirely fair, because CD&R insisted on terms that valued the equity of Ply Gem at around $1.236 billion, although three months earlier, during the Precedent Transaction, CD&R valued Ply Gem’s equity at $638 million. The plaintiff views the merger as a “windfall” for CD&R, as NCI paid a 94% premium for Ply Gem.
The defendants moved to dismiss the complaint for failing to state a claim, on which the court ruled in the instant action. Seven of the director defendants argued that they should be dismissed due to the exculpation clause in NCI’s charter, while four of the director defendants argued that they should be dismissed because they abstained from voting on the merger. The defendants also challenged the unjust enrichment claim.
The court noted that whether CD&R controlled NCI was dispositive for Count I because non-controlling stockholders are not fiduciaries, and affected the standard of review for Count II because if it is reasonably conceivable that CD&R controlled NCI, then the entire fairness standard is the operative standard for purposes of the motion to dismiss. On the other hand, if it is not reasonably conceivable that CD&R controlled NCI, then an irrebutable version of the business judgment rule will govern unless the plaintiff can plead a reasonably conceivable breach of the duty of disclosure. In the absence of a well-pled disclosure claim, the traditional rebuttable version of the business judgment rule governs unless it is reasonably conceivable that the Board lacked a disinterested and independent majority.
The plaintiff alleged that CD&R controlled NCI because it owned over 34.8% of NCI’s voting shares, had four representatives on NCI’s twelve-member board of directors, had relationships of varying significance with another four directors, and had a stockholders agreement in place that gave CD&R contractual veto rights over a wide range of actions that the Board could otherwise take unilaterally.
Accepting the facts as pled, the court largely denied the motion to dismiss stating it was reasonably conceivable that CD&R controlled NCI. In making its decision, the court considered the following factors that highlight potential sources of control: (i) relationships with particular directors, (ii) relationships with key managers or advisors, (iii) the exercise of contractual rights to channel the corporation into a particular outcome, and (iv) the existence of commercial relationships that provide the defendant with leverage over the corporation, such as status as a key customer or supplier. The court found that the nature of relationships between CD&R and a majority of the directors indicated a reasonable inference of control as CD&R nominated and controlled four of the Board’s twelve directors, which comprised one-third of the seats. It also had influence over four other directors. That along with the power and influence CD&R carried through its large voting block of 34.8%, was sufficient to contribute to a reasonably conceivable inference that CD&R exercised control over NCI at the time of the challenged transaction. The court noted that a large voting block can carry significant influence and also gives its owner additional rhetorical cards to play in the boardroom.
As the court found that it was reasonably conceivable that CD&R controlled NCI, the merger was reviewed under the entire fairness standard. The court found the valuation gap between the merger and the Precedent Transaction to be sufficiently large to support a pleading-stage inference of unfairness. In reaching its conclusion, the court considered two basic aspects with respect to the concept of fairness: fair dealing and fair price. Fair dealing “embraces questions of when the transaction was timed, how it was initiated, structured, negotiated, disclosed to the directors, and how the approvals of the directors and the stockholders were obtained.” Fair price “relates to the economic and financial considerations of the proposed merger, including all relevant factors: assets, market value, earnings, future prospects, and any other elements that affect the intrinsic or inherent value of a company’s stock.” The large valuation gap between the merger and the Precedent Transaction supported an inference of financial unfairness.
The plaintiff also challenged the merger for purposes of the fair process aspect of the entire fairness test. The court found that the plaintiff alleged sufficient facts to indicate unfairness at the pleading stage as Evercore, the financial advisor to the special committee formed to evaluate and negotiate the transaction was also advising another CD&R portfolio company while working for NCI’s special committee. Importantly, in its first valuation, Evercore analyzed the merger using the equity evaluation from the Precedent Transaction which supported a post-transaction ownership structure in which NCI’s stockholders would own two-thirds of the equity of the surviving corporation. However, after meeting with CD&R, Evercore revised its valuation methodologies and provided analyses that justified the 57%/43% split. Therefore, the court concluded that the plaintiff had established sufficient facts to survive a motion to dismiss.
The court however, did dismiss the claim against four of the seven individuals who relied on the exculpation clause in NCI’s charter, as the complaint did not identify any compromising relationships or sources of influence between CD&R and those directors. The fact that the Challenged Transaction may have resulted in terms overly generous to CD&R was not sufficient to infer bad faith. The court denied the motion to dismiss based on the exculpation clause brought by the three other directors, finding that they had longstanding ties to CD&R and may have acted out of loyalty to CD&R. The four defendants who relied on abstention as grounds for dismissal were not entitled to dismissal at this stage. Although the defense of abstention may ultimately prevail, the court found it was premature to rule on it at the pleading stage. Finally, the court also denied the motion to dismiss the unjust enrichment claim stating the plaintiff is allowed to plead in the alternative.