The Coster v. UIP Companies, Inc.[1] decision provides a framework for evaluating stockholder disenfranchisement claims.  Directors should carefully consider how, and under what conditions, they will take actions that dilute stockholders’ voting or statutory rights.

Factual Background

In 2018, Marion Coster, a 50% stockholder of UIP Companies, Inc. (UIP), filed suit against UIP and the other 50% stockholder, Steven Schwat.  Ms. Coster inherited her UIP shares in 2015 from her late husband.  At the time of her inheritance, UIP had a five-member board of directors, consisting of Mr. Schwat, two directors aligned with him including Peter Bonnell, and two vacant seats.  Coster attempted to reduce the size of the board and, when that failed, to appoint two directors to the board.  Coster and Schwat were deadlocked and unable to elect new directors.  As a result, Ms. Coster filed suit to request the appointment of a custodian for UIP to break the stockholder deadlock.  In response to the suit, the three directors voted to issue a one-third interest to Bonnell, a director, friend of Schwat, and long-time UIP employee (the Stock Sale).  The Stock Sale diluted both Coster’s and Schwat’s UIP interests below fifty percent, thereby enabling Schwat and Bonnell to break the stockholder deadlock and make moot the request for a custodian.  Coster then filed a second lawsuit, claiming the board breached its fiduciary duties by approving the Stock Sale and asking the court to cancel the Stock Sale.  The Court of Chancery refused to cancel the Stock Sale, even though it was apparent the Stock Sale was intended to dilute Coster’s interest and end the custodian suit.  Ms. Coster appealed.  The Delaware Supreme Court reversed the Chancery Court and remanded with an order to consider the board’s motivations and purposes for the Stock Sale.

Director Duties and Compelling Justification

Delaware corporate law tasks a corporation’s directors with managing corporate business.[2]  As such, when a stockholder invests in a corporation, it inherently places trust in the corporation’s directors to protect that investment through adequate management.  Directors in turn owe fiduciary duties to stockholders.  Delaware courts apply three standards of review when evaluating director decision-making: (1) the business judgment rule; (2) enhanced scrutiny; and (3) entire fairness.[3]  Typically, directors’ actions are found to be reasonable if taken advisedly, in a good faith pursuit of corporate interest, and such actions are reasonable in scope.[4]  In other words, a director’s reasonable exercise of good faith and due care in taking action usually validates its exercise of authority when reviewed through the lens of the business judgment rule.  However, if stockholders are disenfranchised, such as when their ability to vote or select directors is curtailed, then enhanced scrutiny or entire fairness review is warranted.  Enhanced scrutiny requires defendant directors to persuade the court that their motivations were proper and not selfish, and reasonable in relation to their legitimate objective.[5]  The review often ratchets up to entire fairness if a stockholder can show the action in question was not taken by a board majority consisting of disinterested and independent directors.[6]  If entire fairness applies, the court itself must be satisfied that a transaction was the product of both fair dealing and fair price.[7]

At trial, Coster successfully provided facts sufficient to trigger an entire fairness review, but the Chancery Court concluded that the actions taken by the UIP board met their burden under that standard.  The Delaware Supreme Court did not disturb the entire fairness finding.  Instead, it held that the Chancery Court “bypassed a different and necessary judicial review where, as here, an interested board issues stock to interfere with corporate democracy and that stock issuance entrenches the existing board”.[8]  The “different and necessary” judicial review primarily invokes standards from two cases, Blasius Industries, Inc. v. Atlas Corp. and Schnell v. Chris-Craft Industries, Inc.[9]  Schnell recognizes that a board cannot escape judicial review simply by having the legal authority to undertake a given act.[10] In Schnell, the board purposefully, though legally, moved a meeting date and changed its location to prevent a dissident group from attempting a change of control campaign.[11]  That action violated the board’s duty to act equitably toward stockholders.  Blasius held that even though Schnell does not apply when a board acts in good faith, if it acts with a primary purpose of impeding stockholders’ franchise rights, the board must prove a “compelling justification” for its actions.[12]  Directors can take defensive actions to respond to threats like change in control actions if they reasonably believe the change would negatively affect corporate interests; however, the reasonableness and proportionality of defensive actions will be tested by Delaware courts (the “Unocal Test”).[13]  Coster is an extension of existing director duty law,[14] primarily enforcing that director actions are tested twice, first for legal authorization and second for equity, with some elaboration on the scope of equitable behavior.

Key Takeaways

The Coster decision provides a framework for evaluating stockholder disenfranchisement claims.  Directors should carefully consider how, and under what conditions, they will take actions that dilute stockholders’ voting or statutory rights.  Where a board’s actions disenfranchise stockholders, passing an entire fairness review may not be sufficient to avoid breaching fiduciary duties.  If directors act either (i) with an inequitable purpose or (ii) in good faith but for the primary purpose of disenfranchisement, a compelling justification is required to avoid breaching a fiduciary duty.  If a compelling justification for disenfranchising the stockholders does not exist, a Delaware court may not even apply the Unocal Test to consider the reasonableness of the directors’ defensive actions.

[1] Coster v. UIP Companies, Inc., 2020 WL 429906 (Del. Ch. Jan. 28, 2020).

[2] Del. Code Ann. tit. 8, § 141; Quickturn Design Sys., Inc. v. Shapiro, 721 A.2d 1281, 1291 (Del. 1998) (“One of the most basic tenets of Delaware corporate law is that the board of directors has the ultimate responsibility for managing the business and affairs of a corporation.”)

[3] Reis v. Hazlett Strip-Casting Corp., 28 A.3d 442, 457 (Del. Ch. 2011).

[4] See Blasius Industries, Inc. v. Atlas Corp., 564 A.2d 651 (Del. Ch. 1988).

[5] Mercier v. Inter-Tel (Delaware), Inc., 929 A.2d 786 (Del. Ch. 2007).

[6] See, e.g., In re Crimson Expl. Inc. S’holder Litig., 2014 WL 5449419 and Kahn v. M & F Worldwide Corp., 88 A.3d 635, 644 (Del. 2014).

[7] Cinerama, Inc. v. Technicolor, Inc., 663 A.2d 1156 (Del. 1995).

[8] Coster v. UIP Companies, Inc., 2021 WL 2644094 (Del. June 28, 2021).

[9] Schnell v. Chris-Craft Industries, Inc., 285 A.2d 430 (Del. Ch. 1971); Blasius Industries, Inc. v. Atlas Corp., 564 A.2d 651 (Del. Ch. 1988).

[10] 285 A.2d 430 (Del. Ch. 1971).

[11] Id.

[12] Blasius Industries, Inc. v. Atlas Corp., 564 A.2d 651 (Del. Ch. 1988) (Drawing from Aprahamian v. HBO & Company, Del.Ch., 531 A.2d 1204 (1987) and Phillips v. Insituform of North America, Inc., Del.Ch., C.A. No. 9173, mem. op., Allen, C., 1987 WL 16285 (Aug. 27, 1987)).

[13] See Unocal Corp. v. Mesa Petroleum Co., 493 A.2d 946 (Del. 1985).

[14] See Bäcker v. Palisades Growth Capital II, L.P., 246 A.3d 81 (Del. 2021).

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