The business and affairs of a Delaware corporation are managed by its board of directors. The board’s managerial oversight includes deciding whether to pursue a claim belonging to the corporation. A stockholder may demand that the board pursue a claim on behalf of the corporation. By doing so, the stockholder concedes the board’s capacity to properly evaluate pursuit of the claim. Delaware courts defer to the business judgment of the board in such circumstances, and therefore it is very difficult for a stockholder to successfully challenge a board’s decision not to pursue the claim.

To avoid conceding deference to the board, stockholders often opt not to make a demand upon the board, but rather pursue the claim on behalf of the corporation and argue that a board demand would have been futile. In doing so, the stockholder is pursuing a claim derivatively on behalf of the corporation rather than a claim belonging directly to the stockholder. Demand futility requires the stockholder to plead facts demonstrating that the board is incapable of properly exercising its business judgment to evaluate whether to pursue the corporation’s claim. Failure to demonstrate demand futility results in dismissal of the lawsuit.

It is no surprise, therefore, that one of the initial skirmishes in a stockholder-initiated lawsuit is whether demand was futile. Recognizing the potentially outcome-determinative nature of this battle, stockholders have taken to rebutting efforts to dismiss their lawsuits for lack of demand futility by arguing that their claims are not exclusively derivative, but rather are dually derivative and direct. Determining whether a claim is derivative or direct generally turns on who suffered the alleged harm and who will receive the benefit of the recovery or other remedy – the corporation or suing stockholders individually?[1] Although these basic questions seem easily answerable, in practice the result can be less than clear.

Complicating the direct vs. derivative analysis is the ruling in Gentile v. Rosette, where the Delaware Supreme Court determined that a claim may be both direct and derivative if:

“(1) a stockholder having majority or effective control causes the corporation to issue ‘excessive’ shares of its stock in exchange for assets of the controlling stockholder that have a lesser value; and (2) the exchange causes an increase in the percentage of the outstanding shares owned by the controlling stockholder, and a corresponding decrease in the share percentage owned by the public (minority) shareholders.”[2]

The Gentile decision purports to remedy the transactional paradigm where a pure overpayment claim (belonging to the corporation) includes a dilution of the minority stockholders’ voting interest (a claim held directly by the impacted stockholders).

Instead, Gentile has sown confusion and frustrates early disposition of stockholder lawsuits – where the decision whether to pursue the claim arguably should remain within the authority of the corporation’s board.

What is stated by stockholders in a complaint enjoys the benefit of the doubt when challenged by a motion seeking dismissal of the lawsuit. If the stockholder is able to suggest facts fitting within the Gentile transactional paradigm (i.e., dilution of the minority’s voting interest), a conclusion that the claim is dual-natured – direct and derivative – often follows. In those instances, the court is typically inclined to allow the lawsuit to proceed, since there is at least potentially a direct claim by the stockholder.

Recent case law suggests, however, that the Gentile dual-natured claim concept may be in jeopardy. In El Paso Pipeline GP Company, L.L.C.,[3] the Delaware Supreme Court refused to extend the Gentile dual-natured claim concept to a limited partner’s dilution claim against the general partnership. Writing separately in support of the majority opinion in El Paso, Chief Justice Leo Strine questioned the wisdom of Gentile’s holding by pointing out that “[a]ll dilution claims involve, by definition, dilution.” It therefore makes no sense to classify the diminution of voting power of a minority stockholder as a direct claim where they are already stockholders in a controlled company. Indeed, Chief Justice Strine advocated that the dual-natured claim holding in Gentile ought to be overturned.

The Chancery Court has interpreted El Paso to implicitly reject decisions that extended Gentile to any and all dilutive issuance approved by a conflicted board.[4] Following El Paso, the Chancery Court has made clear that to the extent Gentile remains good law, its holding must be confined to its specific facts.[5] That is, there must exist a controlling stockholder who extracts a dilutive stock issuance; not a dilutive stock issuance that results in a controlling stockholder. At least one Chancery Court decision has questioned whether Gentile remains good law following El Paso.[6]

Whether Gentile goes the way of the dinosaurs remains to be seen. As Chief Justice Strine remarked in El Paso, it makes no sense to transform quintessential derivative claims into direct claims merely because a minority stockholder’s voting power is diluted. To do so runs contrary to the strong weight of Delaware precedent reserving overpayment claims to the corporation itself. To the extent a transaction consolidates diverse control to a single controlling stockholder, existing authority provides a direct claim by the disenfranchised stockholders.[7] Hence, the need for a dually direct and derivative claim is arguably unnecessary, making a strong argument for Gentile’s extinction.

[1] Tooley v. Donaldson, Lufkin & Jenrette, Inc., 845 A.2d 1031 (Del. 2004).

[2] 906 A.2d 91, 99-100 (Del. 2006).

[3] 152 A.3d 1248 (Del. 2016).

[4] Sciabacucchi v. Liberty Broadband Corp., C.A. No. 11418-VCG (Del. Ch. July 26, 2018).

[5] Carr v. New Enterprise Associates, Inc., C.A. No. 2017-0381-CB (Del. Ch. Mar. 26, 2018); The Cirillo Family Trust v. Moezinia, C.A. No. 10116-CB, n. 157 (Del. Ch. July 11, 2018); Liberty Broadband, C.A. No. 11418-VCG (Del. Ch. July 26, 2018).

[6] ACP Master, Ltd. v. Sprint Corp., C.A. No. 9042-VCL, n.206 (Del. Ch. July 21, 2017).

[7] Revlon, Inc. v. MacAndrews & Forbes Holdings, Inc., 506 A.2d 173 (Del. 1986).