Key Takeaways

• The Delaware Court of Chancery establishes a new framework for purposes of determining whether minority stockholders should be deemed part of a control group with a stockholder that is already a controller on its own.

• The framework requires more than a “legally significant” connection among the controller and other stockholders. The controller must cede some of its control power to the minority stockholders for those stockholders to be deemed part of a control group with the controller.

• Coordination of actions and a rollover or re-investment by minority stockholders, on their own, do not satisfy this stricter framework.

In a decision of interest to private equity investors, the Delaware Court of Chancery (the “Court”) adopted a new framework for determining whether minority stockholders are part of a control group with a separately controlling stockholder for purposes of extending fiduciary duties to the minority stockholders.

Ruling on a motion to dismiss, the Court applied a stricter framework for finding a control group where a stockholder already holds a controlling interest as compared to the framework applied when determining whether minority stockholders without a controller among them form a control group. The Court held that not only must the minority stockholders and controlling stockholder act in concert in a legally significant way to accomplish a corporate action, but the controlling stockholder must also have ceded some material aspect of control to the minority stockholders to gain their assistance in accomplishing its goal.1

Background

The case arises from the take-private cash-out merger of Connecture, Inc., a provider of software and services for the health insurance industry, by its controlling stockholder Francisco Partners, a private equity firm focusing on technology investments. Connecture entered into a merger agreement with affiliates of Francisco Partners on January 4, 2018, at a price of $0.35 per share. At the time, Francisco Partners funds owned approximately 56% of Connecture.

The transaction involved a rollover by two minority stockholders: Chrysalis Ventures II, L.P. (“Chrysalis”), which owned approximately 11% of Connecture after having invested alongside Francisco Partners in two earlier private placements, and David Jones, Jr., the chairman of the board of Connecture and founder of Chrysalis, who owned 0.02% of Connecture. Chrysalis agreed to roll over its shares only if Francisco Partners raised its offer for the shares of Connecture, which it did by increasing its offer from $0.30 to $0.35 per share. As part of the transaction, Francisco Partners and Chrysalis entered into a voting agreement with Connecture obliging them to vote in favor of the merger.

At no point was the merger conditioned on approval by a majority of the minority stockholders or on the approval of a special committee of independent directors, rendering the transaction and the actions of Francisco Partners reviewable by the Court for entire fairness. The merger ultimately closed despite only receiving 9.9% approval from the non-rolling minority stockholders.

The plaintiff minority stockholders filed suit against Francisco Partners, Chrysalis, Jones, and another director, alleging that the merger price and process were unfair. In making this allegation, the plaintiffs argued that, although Chrysalis and Jones were minority stockholders, they collaborated with Francisco Partners in a legally significant way that bound them to Francisco Partners in a control group. As such, the plaintiffs alleged that Chrysalis and Jones each owed fiduciary duties to Connecture’s other minority stockholders in the same way that Francisco Partners did, subjecting their actions to the more exacting entire fairness standard of review.

Chrysalis and Jones moved to dismiss the suit, arguing that their actions taken in favor of the merger, including rolling their respective shares into the acquisition vehicle, were taken in their capacity as individual stockholders and not as corporate fiduciaries.

Frameworks for Finding Control Group

The Court ruled in favor of Chrysalis’ and Jones’ motion to dismiss, rejecting the plaintiffs’ argument that Chrysalis and Jones formed a control group with Francisco Partners.² In so doing, the Court acknowledged that the plaintiffs may have pleaded enough facts to satisfy the framework for finding a control group among minority stockholders where there is no controlling stockholder, but that the more strenuous framework for forming a control group among minority stockholders and an unrelated and independently controlling stockholder had not been satisfied.

In reaching its decision, the Court explained how a group of minority stockholders together may form a control group under Delaware law. When the potential control group consists only of minority stockholders, the Court applies the traditional framework in which the group of minority stockholders must be connected in a “legally significant way—e.g., by contract, common ownership, agreement or other arrangement”³ for the purpose of accomplishing a shared objective. The mere alignment of “parallel interests” where no legally significant arrangement between the parties exists is insufficient to establish a control group among minority stockholders.⁴

However, the Court held that where a controlling stockholder is already present, even more is required to join the minority stockholders in a group with the controller and extend the controller’s fiduciary duties to these other minority stockholders. For these purposes, the Court adopted the framework described in 2018 in Almond v. Glenhill Advisors LLC,⁵ where the Court first contemplated the possibility of a minority stockholder forming a control group with an unrelated and independently controlling stockholder. The Glenhill Court suggested, and the Court here adopted, a two-pronged approach in which:

• The plaintiff must establish that the minority stockholder and controlling stockholder acted in concert to accomplish a corporate action, as in the traditional framework; and
• The controlling stockholder must have perceived a need to include the minority stockholder in its plans in order to accomplish the controlling stockholder’s goal, with the controlling stockholder ceding some material aspect of control to the minority stockholder to gain their assistance in accomplishing that goal.6

Elaborating on this analytical framework, the Court stated that the fact that a controlling stockholder “merely permitt[ed] participation” by other stockholders in the transaction is insufficient to establish a material ceding of control by the controlling stockholder.7 The Court added that this framework is a template for consideration, as with other equitable analyses, rather than a determinative test.

No Control Group under New Framework

Having adopted the Glenhill analysis for forming a control group with an unrelated and independently controlling stockholder, the Court applied the framework to the plaintiffs’ allegations that the defendant minority stockholders formed a control group with Francisco Partners. The plaintiffs relied on the following principal facts to support a finding of a control group:

• The proxy statement for the merger disclosed that Chrysalis and Jones were “affiliates” of Connecture under applicable SEC rules, and Rule 13e-3 defines “affiliate” using a control test.⁸
• The voting agreement between Francisco Partners and Chrysalis bound them to the shared goal of taking Connecture private.
• Francisco Partners, Chrysalis and, to a lesser extent, Jones had earlier participated exclusively in two private placements in Connecture.
• Jones had helped facilitate Chrysalis’ participation in the going-private transaction and then added his shares to the equity rollover just prior to the closing.

In pleading these facts, the plaintiffs relied heavily on the Court’s decision in Hansen Medical,⁹ a case also involving a rollover, a voting agreement and a history of coordinated investment strategy, where the Court found that the defendant stockholders had formed a control group. The Court here, however, distinguished Hansen Medical, which did not involve an unrelated and independently controlling stockholder and had been decided by applying the traditional control-group framework.

In this regard, the Court noted that Francisco Partners, as the controlling stockholder, had the ability to approve the transaction without the participation of any other stockholder, requiring that the plaintiffs plead facts that satisfy the second prong of the Glenhill analysis. To this, the plaintiffs could only note, in the Court’s view, that Francisco Partners had agreed to a dilution of its equity ownership of the post-acquisition corporation by letting Chrysalis and Jones roll over their respective equity interests in Connecture, a “self-imposed limitation on Francisco Partners’ self-interest.”¹⁰ The Court found this to be insufficient, holding that mere dilution of the controlling stockholder’s interest does not establish a significant limitation on the controller’s ability to exercise control over the corporation. If it did, the Court noted, every time minority stockholders diluted a controller by participating in a transaction alongside the controller, the rollover stockholders would be tagged as controlling fiduciaries owing duties to the corporation and the other stockholders.¹¹

As a result, the Court found that Chrysalis and Jones did not owe the other minority stockholders any fiduciary duties and were entitled to roll over their equity interests as they saw fit.

Key Takeaways

The exercise of control by a stockholder over a corporate action can trigger strict judicial review that, in turn, can impede or delay transactions and lead to litigation costs and awards of damages. For these reasons, the decision in Connecture provides comfort for minority stockholders who collaborate with a controlling stockholder in meaningful ways—including by rolling over shares in a going-private transaction, entering into a voting agreement, and even coordinating or facilitating the transaction—that they are not likely to be held to owe fiduciary duties absent other circumstances. The decision establishes that minority and controlling stockholders can act in concert to accomplish a corporate action without the minority stockholder being captured in a control group. Rather, the controlling stockholder must have needed the participation of the relevant minority stockholders and ceded some of its control to them in furtherance of its objective. Dilution of the controlling stockholder’s equity ownership in the post-acquisition company by virtue of a rollover by minority stockholders is itself insufficient (independent of other factors) to establish that a control group exists. Indeed, the Connecture decision expressly acknowledges that a control group of both minority and unrelated and independently controlling stockholders is an unlikely scenario.

The new framework creates a somewhat interesting juxtaposition, in which it may be easier for minority stockholders to be deemed part of a control group where there is no separate controlling stockholder than if there already is one. It is also notable that in a deal subject to scrutiny for its entire fairness, which was approved by a small fraction of the minority stockholders, and in which only certain minority stockholders were given the opportunity to roll over their shares, the Court still declined to attach any fiduciary duties to the rolling minority stockholders. The Court in Connecture does not elaborate on the doctrinal underpinnings for the distinction between the two control-group scenarios, other than to note that if the minority stockholders do not control the corporate machinery, they should not owe fiduciary duties to the corporation or its other stockholders. It appears that the Court is primarily focused on who operates the levers of control, not merely on who benefits from them.