Key Takeaways

• Under Delaware law, following the acquisition of an entity through a cash-out or stock-for-stock merger, equityholders generally lose standing to pursue derivative claims in the name of the acquired entity unless certain limited exceptions apply.
• In 2015, Delaware’s Chancery Court, in Primedia, established a three-part test for determining when former equityholders have standing to pursue post-merger direct claims for a controller’s alleged failure to secure the value of a material derivative claim during the merger negotiations.
• Delaware’s Supreme Court has now, through Spectra Energy, adopted the Primedia test, but with two important clarifications:
  • Apart from making a threshold determination about plaintiff’s allegations, a trial court may not apply any further litigation risk discount in assigning value to the plaintiff’s claims on a motion to dismiss.
  • Trial courts must assess the materiality of the claim based on a consistent comparison of the claim to the value of the merger consideration.
• When facing a derivative claim that may later be pursued as a post-merger direct claim, Delaware companies should carefully consider (a) whether to assign value to the derivative claim, (b) how the Primedia test may affect the status of litigation post-merger, and (c) how materiality will be viewed by courts after the transaction is completed.

Summary

In Morris v. Spectra Energy Partners (DE) GP, LP,¹ the Delaware Supreme Court clarified the test for determining when former equityholders have standing to pursue post-merger direct claims for a controller’s alleged failure to secure the value of a material derivative claim during the merger negotiations. Under Delaware law, and following the acquisition of an entity through a cash-out or stock-for-stock merger, equityholders generally lose standing to pursue derivative claims in the name of the acquired entity unless certain limited exceptions apply.² But the Delaware courts have recognized that a former equityholder may plead a direct claim that the merger itself was unfair, “by charging the directors with breaches of fiduciary duty resulting in unfair dealing and/or unfair price.” Thus, a post-merger claim where a controller of the entity “failed to secure the value of material derivative claims . . . for the minority equity owners” is a direct claim that former equityholders can pursue without complying with the procedural hurdles that apply in derivative cases.³ When pursuing such claims, the issue of whether the underlying derivative claims were “material” to the merger may be a threshold standing issue litigated at the motion to dismiss stage.⁴

In Spectra Energy, the Supreme Court endorsed the three-part standing test developed by the Chancery Court in In re Primedia, Inc. Shareholders Litigation⁵ and clarified that, when assessing the materiality of the underlying derivative claims at the pleadings stage, trial courts may assess whether or not it is “reasonably conceivable” that the plaintiff could recover on the claims but may not “[a]pply a further litigation risk discount.”⁶

I. Proceedings Before the Chancery Court

Plaintiff, a public unitholder in the master limited partnership SEP, brought a derivative suit in the name of SEP against its general partner, SEP GP.⁷ SEP GP moved to dismiss under Chancery Rule 12(b)(6), but the Chancery Court denied the motion, holding that Plaintiff had pled facts sufficient to state a claim for breach of the partnership agreement against SEP GP.⁸

The litigation proceeded until SEP was acquired by Enbridge through a transaction in which SEP public unitholders received Enbridge common stock.⁹ Upon completion of the merger between SEP and Enbridge, Plaintiff and SEP GP voluntarily stipulated to the dismissal of Plaintiff’s derivative action.¹⁰ Thereafter, Plaintiff brought a direct suit in Chancery Court against SEP GP, alleging that it had agreed to the merger in bad faith because it failed to receive any value for the previously asserted derivative claim.¹¹  

Defendant moved to dismiss, arguing, inter alia, that Plaintiff lacked standing to pursue its direct claim because the underlying derivative claim was immaterial to the overall value of the Enbridge-SEP merger.¹² The Chancery Court applied the Primedia test to determine whether Plaintiff had standing to pursue the action directly.¹³ The Primedia test requires a court to consider three questions: 

1) Was the underlying claim viable?

2) Was its value material in light of the merger consideration?

3) Did the company fail to receive value for the claim in the merger because the buyer would not be willing to pursue it? Here, the parties did not dispute that Plaintiff’s claim satisfied the first and third parts of the Primedia test.  

Here, the parties did not dispute that Plaintiff’s claim satisfied the first and third parts of the Primedia test.¹⁴

Thus, the only question in dispute was whether the value of the claim was material in light of the total consideration offered in the Enbridge-SEP merger. Plaintiff contended that his derivative claim “could lead to a more than $660 million damages award, including prejudgment interest, and that amount was material to the $3.3 billion in total consideration for the Enbridge-SEP merger.”¹⁵ Defendant countered that Plaintiff’s calculation of damages was overstated because the affected minority equityholders owned just 17% of the total equity value of SEP and so the recovery Plaintiff could actually obtain would be just 2.85% of the total consideration offered in the Enbridge-SEP merger—an amount Defendant argued was not material.¹⁶

The Chancery Court agreed with Defendant regarding the materiality of Plaintiffs' potential recovery. To Plaintiff’s alleged damages of $661 million, the Chancery Court applied an approximately 83% discount to reflect the public unitholders’ beneficial interest in the derivative litigation and a further 75% discount to reflect the likelihood of success.¹⁷ Applying both discounts, the likely value of the claims was less than 1% of the merger consideration, or an immaterial amount.¹⁸ The Chancery Court granted Defendant’s motion to dismiss, concluding that Plaintiff did not have standing because the claim was immaterial.¹⁹

 II. The Delaware Supreme Court’s Reversal

On appeal, the Delaware Supreme Court reversed. The Court adopted the Primedia test for standing to pursue post-merger claims challenging the valuation of underlying derivative claims in merger negotiations, but held that the Chancery Court erred in assessing the materiality of the asserted claim.²⁰

The Delaware Supreme Court recognized that the Chancery Court has the authority to dismiss a direct shareholder claim for lack of standing if the claim is “meritless” or “immaterial.”²¹ Nevertheless, in this case, the Delaware Supreme Court held that the Chancery Court erred in finding the underlying derivative claim was “meritless” or “immaterial” for two reasons.²²

First, the Delaware Supreme Court emphasized that “the court must accept [Plaintiff’s] factual allegations as true and draw all reasonable inferences in his favor.”²³ In other words, “if it is reasonably conceivable that the plaintiff could recover the damages claimed in the complaint, the court must accept that allegation as true for purposes of the motion to dismiss for lack of standing.”²⁴ The Delaware Supreme Court therefore held that, apart from making this threshold determination about plaintiff’s allegations, a trial court may not apply “a further litigation risk discount at the pleading stage . . . on a motion to dismiss for lack of standing.”²⁵ Accordingly, the Delaware Supreme Court found that it was error for the Chancery Court to apply a 75% litigation risk discount based on the court’s assessment of Plaintiff’s chances of success at 25%.²⁶

Second, the Delaware Supreme Court clarified that the Chancery Court must assess the materiality of the claim based on a consistent comparison of the claim to the value of the merger consideration. And so, it was error for the Chancery Court to compare, on the one hand, the value of the claims to a limited group of equityholders, to the entity’s total equity value as determined by the merger. Materiality should instead be calculated by comparing the value of the claim to the subset of affected equityholders to the specific consideration those equityholders received in the merger, or by comparing the total value of the claim to the entity as a whole to the total consideration provided in the merger.²⁷

Thus, the Delaware Supreme Court found that, even if the $660 million claim was discounted to $112 million—representing the “public unitholders’ interest in the derivative recovery, to maintain equivalence—the court should have compared the $112 million pro rata interest in the derivative claim recovery to the public unitholders’ proportional interest in the merger consideration.”²⁸ The Delaware Supreme Court therefore held that, considering both the value of the claim and the value of the merger consideration on a pro rata basis, the $112 million sought by the claim was material to the merger consideration of $561 million.²⁹

The key takeaway from this ruling is that the “[C]ourt’s materiality analysis at the motion to dismiss stage of the proceedings” requires a “reasonably conceivable” claim analysis, which prohibits the application of a litigation risk discount and further requires that materiality be considered from the standpoint of the whole corporation.³⁰

III. Conclusion

The Delaware Supreme Court’s ruling is important because it clearly adopts the Primedia test and thus represents an incremental move toward broader standing to assert post-merger claims relating to the value of derivative litigation. When an entity faces a derivative claim that may later be pursued as a post-merger direct claim, Delaware corporations, limited liability companies, and partnerships should carefully consider whether to assign value to the derivative claim, how the Primedia test may affect the status of post-merger litigation, and how materiality will be viewed by courts after the transaction is completed. 

Footnotes

1) --- A.3d ----, No. 489, 2019, 2021 WL 221987 (Del. Jan. 22, 2021).
2) El Paso Pipeline GP Co. v. Brinckerhoff, 152 A.3d 1248 (Del. 2016); Parnes v. Bally Entertainment Corp., 722 A.2d 1243, 1245–46 (Del. 1999). 
3) Spectra Energy, 2021 WL 221987, at *6. 
4) See In re Massey Energy Co. Deriv. & Class Action Litig., 2011 WL 2176479, at * (Del. Ch. May 31, 2011); Golaine v. Edwards, No. CIV.A. 15404, 1999 WL 1271882, at *10 (Del. Ch. Dec. 21, 1999); In re Primedia, Inc. S’hlders Litig., 67 A.3d 455, 477 (Del. Ch. 2013).  
5) 67 A.3d 455 (Del. Ch. May 10, 2013).  
6) Spectra Energy, 2021 WL 221987, at *11 (“[W]e think that the Primedia framework provides a reasonable basis to conduct a pleadings-based analysis to evaluate standing on a motion to dismiss.”), *12 (Where it “was . . . reasonably conceivable” that Plaintiff could have prevailed on its claims, “[a]pplying a . . . litigation risk discount at the pleading stage was inconsistent with the court’s standard of review on a motion to dismiss for lack of standing.”).  
7) 2021 WL 221987, at *2.  
8) 2021 WL 221987, at *3; see also Morris v. Spectra Energy Partners (De) GP, LP, C.A. No. 12110-VCG, 2017 WL 2774559, at *10 (Del. Ch. June 27, 2017).  
9) 2021 WL 221987, at *2–3.  
10) 2021 WL 221987, at *3.  
11) 2021 WL 221987, at *3.  
12) 2021 WL 221987, at *3. 
13) 2021 WL 221987, at *11.  
14) 2021 WL 221987, at *11.  
15) 2021 WL 221987, at *11.  
16) Def.’s Op. Br. in Supp. of Mot. to Dismiss at 30–31, C.A. No. 2019-0097-SG, 2019 WL 1744647 (Apr. 15, 2019).  
17) 2021 WL 221987, at *11.  
18) 2021 WL 221987, at *11.  
19) 2021 WL 221987, at *11. 
20) 2021 WL 221987, at *1, *11.  
21) 2021 WL 221987, at *11.  
22) 2021 WL 221987, at *11–12.  
23) 2021 WL 221987, at *11–12, n.74.  
24) 2021 WL 221987, at *11.  
25) 2021 WL 221987, at *11.  
26) 2021 WL 221987, at *1, *12.  
27) 2021 WL 221987, at *12.  
28) 2021 WL 221987, at *12. 
29) 2021 WL 221987, at *12. 
30) Id.