On March 15, 2013, the Delaware Court of Chancery denied motions to dismiss filed by a group of director defendants and certain affiliated funds for claims brought by a group of stockholders. The claims allege that the stockholders' interests had been wrongfully diluted by the defendants through self-dealing issuances of preferred stock over several years, which ultimately resulted in the defendants taking control of the company.
In connection with a merger resulting in the sale of the company for $82.5 million, the plaintiffs, who originally founded the company but retained less than 1 percent equity ownership at the time of the merger, received less than $36,000, collectively. The management team, on the other hand, received transaction bonuses of $15 million and the preferred stockholders received nearly $60 million in liquidation preferences. The plaintiffs sued the board of directors and affiliated funds of the directors, challenging the dilutive stock issuances, the allocation of the $15 million in merger proceeds to the management team and the overall fairness of the merger.
In their complaint, the plaintiffs alleged that the board of directors breached its fiduciary duties by wrongly diluting the plaintiffs' equity interest through a series of self-interested stock issuances that were approved by the board of directors. After analyzing various jurisdictional and other defenses, the court turned to the defendants' contention that the plaintiffs' claims for breach of fiduciary duty were derivative, and thus the plaintiffs' standing to sue was extinguished by the merger.1 To determine whether a claim is derivative or direct, 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 then noted that, although each question is framed as a choice between mutually exclusive alternatives (i.e.,either the corporation or the stockholders), "some injuries affect both the corporation and stockholders," and that if that dual aspect is present, a plaintiff can choose to sue individually. Ultimately, the court concluded that a dilutive stock issuance can have the requisite dual character of causing injury to both the corporation and the stockholders. The court stated:
If a complaint contends that the corporation received too little for its shares, then in one sense, the injury is suffered by the corporation, which was harmed because it did not receive greater value in exchange. But in another sense, the effects of a stock issuance are felt primarily by the stockholders. Stock has value only to the extent it provides its holders with rights, such as the right to vote, to receive dividends when declared and paid, or to claim a share of net assets in liquidation.
Although the court struggled with the "potential to undercut the traditional characterization of stock dilution claims as derivative," it also recognized that the Delaware Supreme Court acknowledged in Gentile v. Rossette, 906 A.2d 91, 99-100 (Del. 2006), that "[t]here is ... at least one transactional paradigm — a species of corporate overpayment claim — that Delaware case law recognizes as being both derivative and direct in character." In the court's view, the Delaware Supreme Court's decisions "preserve stockholder standing to pursue individual challenges to self-interested stock issuances when the facts alleged support an actionable claim for breach of the duty of loyalty." This would include where a controlling stockholder stood on both sides of the transaction, if the board that effectuated the transaction lacked a disinterested and independent majority, but not where there is no reason to infer disloyal expropriation, such as when the stock is issued to an unaffiliated third party as part of an employee compensation plan or when the terms are approved by a majority of disinterested and independent directors.
Thus, the court concluded that the plaintiffs pleaded a direct claim against the board of director defendants because each financing challenged "was a self-interested transaction implicating the duty of loyalty and raising an inference of expropriation." The plaintiffs also stated a direct claim against the fund defendants, the court found, because the fund defendants and their director representatives can be regarded as a control group for purposes of Gentile, which allows for standing where the complaint states that "a number of shareholders, each of whom individually cannot exert control over the corporation ... collectively form a control group [and] are connected in some legally significant way — e.g., by contract, common ownership, agreement, or some other arrangement — to work together toward a shared goal."
This decision is significant because, previously, under the Delaware Supreme Court's decision in Gentile, dilution claims were considered direct only when a majority or controlling stockholder caused the dilution for his or her personal benefit. The Chancery Court's decision appears to permit direct suits for dilution when corporate insiders merely participate in the dilution of other stockholders' equity interests. Additionally, the court's decision appears to expand the ability of stockholders to challenge the terms of a merger that has purportedly wrongly diverted merger consideration to management. Thus, those claims may now survive a merger as direct claims, whereas in a derivative action they would have been extinguished.
The opinion is Carsanaro v. Bloodhound Tech., Inc., C.A. No. 7301-VCL, (Del. Ch. Mar. 15, 2013) and is available at: http://courts.delaware.gov/opinions/download.aspx?ID=186730
1 Under Delaware law, a cash-out merger eliminates a stockholder's right to bring a derivative claim because only a current stockholder may continue to assert a derivative claim.