Topic: Entire Fairness

MAINTAINING GOOD CORPORATE GOVERNANCE: ENTIRE FAIRNESS CREEPING INTO ACTIONS BENEFITING A CONTROLLING STOCKHOLDER

By: Scott Waxman and Rich Minice

In Tornetta v. Musk, Civil Action No. 2018-0408-JRS (Del. Ch. Sep. 30, 2019), the Delaware Court of Chancery addressed the appropriate standard of review to apply when examining stockholder approval of a conflicted controller for the controller’s own executive incentive compensation package. In January 2018, Tesla, Inc.’s board of directors (the “Board”) approved a compensation package (the “Award”) for its CEO, Elon Musk. The Board then submitted the Award to Tesla’s stockholders for approval. The Award was overwhelmingly approved. Tornetta (“Plaintiff”), a Tesla stockholder, brought four direct and derivative claims against Musk and members of the Board (the “Defendants”) alleging the Award is a product of breaches of fiduciary duty, constitutes waste, and unjustly enriches Musk. The Defendants moved to dismiss all counts under Rule 12(b)(6) (the “Motion”).

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Delaware Court of Chancery Allows Stockholder’s Derivative Claim to Proceed Against Alleged Controlling Stockholder Under Entire Fairness Standard of Review

By Scott E. Waxman and Frank Mazzucco

In Reith v. Lichtenstein et al., C.A. No. 2018-0277-MTZ (Del. Ch. Jun. 28, 2019), the Delaware Court of Chancery, in considering a motion to dismiss, allowed a stockholder’s derivative complaint to proceed against a minority stockholder under the entire fairness standard of review, because the complaint had sufficiently alleged that such minority stockholder, by exercising “actual control” as part of transactions being challenged, was effectively a controlling shareholder and thus owed fiduciary duties.

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Delaware Court of Chancery Applies Entire Fairness Review in Finding That Controlling Stockholders and Special Committee Members Breached Fiduciary Duties to Target Stockholders

By Lisa Stark and Frank Mazzucco

In FrontFour Capital Group LLC v. Taube, C.A. No. 2019-0100-KSJM (Del. Ch. Mar. 11, 2019), the Delaware Court of Chancery found that, due to their conduct in connection with two mergers of affiliated entities, controlling stockholders and special committee members breached their fiduciary duties to target stockholders under the entire fairness standard of review and failed to provide certain material disclosures to stockholders.

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Court to Sellers: Stockholder Notice Rights Matter

By Scott Waxman and Nadia Brooks

In Mehta v. Mobile Posse, Inc., six causes of action were before the Delaware Court of Chancery in Plaintiff’s complaint alleging inadequate stockholder notice and breach of directors’ fiduciary duty of disclosure regarding the merger of Mobile Posse. The defendants, Mobile Posse and its board, asserted motions for judgments on the pleadings for all counts, arguing they were entitled to the judgments because the violations were remedied by the supplemental notice they issued. The Court denied all but one of defendants’ motions, finding numerous deficiencies in the notice process and finding that the merger was not entirely fair.

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CHANCERY COURT DISMISSES COMPLAINT FOR FAILURE TO STATE A CLAIM, HOLDING THAT REVIEW OF SALE UNDER ENTIRE FAIRNESS IS NOT WARRANTED

By: Joanna Diakos and Adam Heyd

In Aron English and Richard Peppe v. Charles K. Narang, et al., C.A. No. 2018-0221-AGB (Del. Ch. March 20, 2019), the Delaware Court of Chancery (the “Court”) dismissed a stockholder suit against the board members of NCI, Inc., a publicly-traded company (the “Company”), for failure to state a claims for relief in connection with allegations of breach of fiduciary duty, and against H.I.G. Capital, LLC (“HIG”) for aiding and abetting such breach during a sale of the Company to HIG.  The Court held that the controlling stockholder’s alleged need for liquidity was not sufficient to compel review of the Company sale under an “entire fairness” standard, and that the vote of stockholders approving the sale was fully informed.

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Chancery Court Grants Preliminary Injunction Restraining Former Director from Selling Shares Allegedly Invalidly Issued to Himself

By: Annette Becker and Michael Payant

In Applied Energetics, Inc. v. George Farley and AnneMarieCo., LLC (C.A. No. 2018-0489-TMR), the stockholders of Applied Energetics, Inc. (“AE” or “Plaintiff”) sued defendants George Farley (“Farley”) and his family owned-holding company AnneMarieCo., LLC (“AMC”) for issuing stock to himself and transferring such shares to AMC in a self-interested transaction.  Plaintiff sought a preliminary injunction to restrain defendants from selling AE shares during the pendency of the stockholder litigation. The Delaware Court of Chancery (the “Court”) granted the preliminary injunction holding that AE established reasonable probability of success on the merits for its claims.

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Surgery Partners, Inc. Fails to Excise Conflicts Infecting Three Interdependent Transactions

by David L. Forney and Tom Sperber

In Klein v. H.I.G. Capital, L.L.C., et. al, C.A. No. 2017-0862-AGB, the Delaware Chancery Court issued a Memorandum Opinion granting in part and denying in part a motion to dismiss under Court of Chancery Rule 23.1 for failing to make a demand and under Court of Chancery Rule 12(b)(6) for failing to state a claim of relief. Melvyn Klein (“Plaintiff”), a stockholder of Surgery Partners, Inc. (“SP”), brought direct and derivative claims against one of SP’s directors Michael Doyle (“Doyle”), SP’s controlling stockholder H.I.G. Capital, L.L.C. (“HIG”), and Bain Capital Private Equity, LP (“Bain”) (collectively, “Defendants”), alleging breaches of fiduciary duty against Defendants stemming from three interdependent transactions that were allegedly conflicted and unfair. The Court found that demand was futile because the Plaintiff sufficiently alleged that the board was interested, and found that Plaintiff stated claims for breach of fiduciary and aiding and abetting breach of fiduciary duty by HIG and Bain, respectively, because Defendants failed to show that the conflicted transactions were entirely fair.

The board of directors of SP (the “Board”) approved, and SP entered into, three transactions on May 9, 2017 (the “Transactions”). The Transactions consist of: (1) SP acquiring National Surgical Healthcare for $760 million; (2) HIG selling its shares of SP to Bain at a price of $19 per share; and (3) SP issuing to Bain 310,000 shares of a new class of stock of SP at a price of $1,000 per share. These transactions were interrelated and dependent on each other; if one fell through, the others would fail as well. The Board approved the Transactions without a special committee and with no publicly disclosed abstentions. No public stockholders voted on the transactions as HIG approved each by written consent as majority stockholder. Bain and SP used the same law firm and accounting firm to represent them during negotiations. Once the Transactions were finalized, Bain was SP’s controlling stockholder.

Plaintiff filed a complaint alleging eight claims. Of those claims, four were pled directly and four were pled derivatively. Each direct claim had a corresponding derivative claim. Counts I and V asserted claims for breach of fiduciary duty against the Board of LP (all of whom were dropped from the complaint except for Doyle) for entering into the Transactions without ensuring that the share issuance to Bain was entirely fair. Counts II and VI were claims for breach of fiduciary duty against Bain and HIG for entering into a conflicted transaction in the share issuance to Bain. Counts III and VII alleged claims of breach of fiduciary duty against HIG, in the alternative, as the sole controlling stockholder for entering into the conflicted transaction. Lastly, Counts IV and VIII asserted that Bain aided and abetted breaches of fiduciary duty by HIG and Doyle.

In deciding Defendants’ motion to dismiss, the Court first turned to whether Counts I-IV were properly brought as direct claims. The Court observed that the claims brought by Plaintiff constitute “a classic form of an ‘overpayment’ claim,” which must normally be pled derivatively. Plaintiff, however, argued that his claim resembles the claim brought in Gentile v. Rosette, where the Delaware Supreme Court recognized a situation where a corporate overpayment claim implicated both direct and derivative injury. The Court, in rejecting Plaintiff’s argument, cited several subsequent Delaware cases that limited the holding in Gentile to its facts and applied it only where the challenged transaction resulted in an improper transfer of both economic value and voting power from the minority stockholders to the controlling stockholder. The Court also observed that not only was Bain not yet the controlling stockholder before the share issuance, but that even if it was, its increase in voting power would not have been so great as to have triggered the Gentile rule. Furthermore, the Court pointed to the structure of the share issuance for the proposition that common stockholders’ shares will only be diluted if and when Bain converts its preferred shares into common stock. Ultimately, the Court found that Plaintiff’s claims could not be brought directly, and therefore dismissed Counts I-IV.

The Court next turned to the question of whether Plaintiff was excused from making demand on the Board on the basis of demand futility. In assessing Plaintiff’s futility allegation, the Court applied the test articulated in Aronson v. Lewis, under which a Plaintiff must “provide particularized factual allegations that raise a reasonable doubt that (1) the directors are disinterested and independent [or] (2) the challenged transaction was otherwise the product of a valid exercise of business judgment.” Of the Board’s seven members, Plaintiff conceded that two were disinterested, while Defendants conceded that three were interested. The Court, therefore, was tasked with determining whether either of the two remaining directors, Doyle and Brent Turner, were conflicted. The Court found that the complaint raised a reasonable doubt as to whether Doyle could make decisions regarding the Transactions independently by alleging that SP engaged him in a consulting agreement that paid him more per month than he made as SP’s CEO. On that basis, the Court found that Plaintiff had properly alleged that making demand on the board was futile.

Once the Court determined that demand was excused, it addressed the merits of Plaintiff’s remaining claims (V-VIII). First, the Court turned to Count VI, which argued in the alternative that Bain and HIG had breached fiduciary duties by acting as a “control group.” The Court dispatched Plaintiff’s argument quickly by pointing out that there was never any allegation that Bain owned any stock, let alone a controlling percentage of stock, prior to the Transactions. Ultimately, the Court dismissed Count VI for failing to state a claim.

The Court then examined Count VII, in which Plaintiff alleged that HIG breached its fiduciary duty by issuing the new shares to Bain. The Court determined that entire fairness was the proper standard of review, observing that that standard is triggered when a controlling stockholder effectuates a conflicted transaction. The Court determined that HIG was conflicted in entering into the issuance of new shares to Bain because that transaction was a condition precedent to HIG’s sale of its own shares to Bain. Entire fairness is an onerous standard for a defendant to overcome, requiring the controlling stockholder to “show, conclusively, that the challenged transaction was entirely fair based solely on the allegations of the complaint and the documents integral to it.” Because Defendants failed to show entire fairness, the Court denied Defendants’ motion to dismiss Count VII.

Count VIII alleged that Bain aided and abetted HIG’s breach of fiduciary duty. The Court found that Plaintiff’s allegations that Bain was aware of its shared legal representation with HIG, as well as the interrelated nature of the three transactions, and the lack of a stockholder vote, inferred Bain’s “knowing participation” in HIG’s breach. The Court, therefore, denied Defendants’ motion to dismiss as to Count VIII.

Lastly, due to the inclusion of an exculpatory provision in SP’s certificate of incorporation, the Court dismissed Plaintiff’s Count V for failing to allege that Doyle acted in bad faith or had personal interest in the transactions.

Board’s Lack of Independence from Interested Director Excuses Stockholder Demand as Futile

By: Christopher B. Tillson and J. Tyler Moser

In Sciabacucchi v. Liberty Broadband Corp., et al., C.A. No. 11418-VCG (Del. Ch. July 26, 2018), the Delaware Court of Chancery denied in part a motion to dismiss brought by defendants Liberty Broadband Corporation (“Liberty”), Liberty’s largest stockholder, and the board of directors of Charter Communications, Inc. (“Charter,” and collectively “Defendants”), for failure to plead demand futility.  The Court ruled that the Plaintiff, a stockholder of Charter, pleaded sufficient facts to support a reasonable inference that the influence of Liberty’s largest stockholder would prevent the Charter board of directors from exercising independent and disinterested business judgment when considering a demand to bring a lawsuit on behalf of the corporation.

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CONTROLLER BREACHES FIDUCIARY DUTIES BY COERCING ONEROUS FINANCING TERMS

By: Kent Carlson and Rich Minice

In Basho Technologies, Inc. v. Georgetown Basho Investors, LLC, C.A. No. 11802-VCL (Del. Ch. July 6, 2018), the Delaware Court of Chancery reaffirmed the principle that a stockholder with actual control of a corporation violates its fiduciary duties by advancing its own interests to the detriment of the corporation.  Applying the entire fairness standard in its decision following trial, the court held that Georgetown Basho Investors, LLC (“Georgetown”), the controlling stockholder of Basho Technologies, Inc. (“Basho”), owed and breached fiduciary duties to Basho as a stockholder with actual-but not majority-control. The court ultimately awarded plaintiffs Earl Gallaher (“Gallaher”) and various investment funds under his control (the “Plaintiff(s)”) damages in the aggregate amount of $20,268,878.

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A Conflicted Controller Transaction Survives a Motion to Dismiss

By: Lisa R. Stark and Samira F. Torshizi

In In re Hansen Medical, Inc. Stockholders Litigation, C.A. No. 12316-VCMR (Del. Ch. June 18, 2018), the Delaware Court of Chancery found that plaintiffs had stated a reasonably conceivable claim that the acquisition of Hansen Medical, Inc. (“Hansen”) by Auris Surgical Robotics, Inc. (“Auris”) should be reviewed under the entire fairness standard of review because the transaction involved a controlling stockholder group which extracted benefits from the transaction not shared with the minority. The Court denied motions to dismiss filed by the alleged control group and Hansen’s directors and officers.

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CHANCERY COURT FINDS TRANSACTION STRUCTURE CAN TRIGGER PRESUMPTIONS OF BUSINESS JUDGMENT DEFERENCE AT PLEADING STAGE

Nicholas Oleinik…v. Frank A. Lodzinski, et al., and Earthstone Energy,…

By: Carty Bibee and Samantha Beatty

In Olenik v. Lodzinski, C.A. No. 2017-0414-JRS (Del. Ch. July 20, 2018), the Court of Chancery, in a motion to dismiss, found that Earthstone Energy, Inc.’s (“Earthstone”) decision to employ the framework laid out in Kahn v. M&F Worldwide, Corp., 88 A.3d 635 (Del. 2014) (“MFW”) in structuring a transaction secured the benefit of the business judgment rule for its fiduciaries, even at the pleadings stage.  The Court found that where the Plaintiff failed to plead waste, or facts which the Court could reasonably conceive as waste, the Plaintiff’s claim that officers and the controlling stockholder breached their fiduciary duties by approving an unfair transaction as interested parties, must be dismissed.

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CONTROLLING STOCKHOLDER CANNOT ADVANCE ITS OWN SELF-INTEREST AT EXPENSE OF MINORITY STOCKHOLDERS

By: C. J. Voss and Rich Minice

In Carr v. New Enterprise Associates, Inc., C.A. No. 20170381-AGB (Del. Ch. Mar. 26, 2018), the Delaware Court of Chancery, in denying in part and granting in part a motion to dismiss, reaffirmed the principle that a controlling stockholder, when acting outside its capacity as a stockholder, cannot use the corporation to advance the controlling stockholder’s self-interest at the expense of minority stockholders.  In the context of defendants’ motion to dismiss, the court found that it was reasonably conceivable that the controlling stockholder of American Cardiac Therapeutics, Inc. (“ACT”) and its conflicted board of directors had breached their duty of loyalty to ACT’s minority stockholders by approving a sale of a warrant to a third party that included an option to acquire ACT, allegedly at an unfairly low price, in order to incentivize the third party to also acquire and invest in the controlling stockholder’s other portfolio companies.

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