• The Court of Chancery confirms that a controlling stockholder exercising stockholder-level voting powers to change the status quo owes limited fiduciary duties not to harm the corporation and its stockholders intentionally, knowingly or by taking grossly negligent actions.
• Unlike a director, a controlling stockholder exercising its voting power is not obligated to take affirmative steps to promote the corporation’s best interests.
• The Court applied enhanced scrutiny when evaluating the controller’s action to amend bylaws and remove directors, and concluded that even under enhanced scrutiny such actions did not breach the controlling stockholder’s limited fiduciary duties in its capacity as a stockholder.
• The Court did not address whether a controller’s use of its voting power to change the status quo on a “clear day” would be reviewed under enhanced scrutiny or the more deferential business judgment rule.
• The Court also held that a subsequent minority buy-out was not entirely fair, but the damage to the minority shareholders was far less than they claimed.

In a landmark decision, In re Sears Hometown & Outlet Stores, Inc. Stockholder Litigation,¹ the Delaware Court of Chancery held that a controlling stockholder did not breach his fiduciary duties when he amended company bylaws and removed two directors in response to a “perceived threat.” Vice Chancellor J. Travis Laster further applied enhanced scrutiny to review the controller’s exercise of his voting rights to block decisions taken by the board of directors, finding the controller’s actions passed the test. In reaching its decision, the Court acknowledged the lack of precedent on which standard of review should apply and framed its new rule as the “controller-oriented version of a situation where enhanced scrutiny should apply.” As to the controller’s subsequent acquisition of the company, the Court separately conducted an entire-fairness review to conclude that the controller underpaid, and the minority stockholders were entitled to recover $18.3 million.

Background

Investor Eddie Lampert held a majority stake in Sears Hometown and Outlet Stores, Inc. (the “Company”) through his investment firm but did not take an active role in management. The Company conducted business through two separate entities: “Hometown,” a segment consistently incurring losses, and “Outlet,” a separate line of retail stores that became profitable after years of operating in the red.²

In 2016, the board created a three-person special committee in anticipation of a transaction between the Company and Lampert. When no transaction materialized, in 2018, the board proposed a plan to liquidate Hometown and focus on growing Outlet’s profits. Lampert disagreed with the liquidation plan, arguing the board underestimated the risks associated with a retail liquidation without bankruptcy protections, and risked destroying stockholder value.³ Lampert sought to avoid the crisis by negotiating with a special committee of the board to acquire the Company, but his offers were rejected.⁴

The board resolved to move forward with a Hometown liquidation despite Lampert’s concerns. In response, Lampert exercised his power as the majority stockholder to amend the bylaws by written consent, requiring the Hometown liquidation to receive 90% board approval and two votes, a month apart, before taking effect. Lampert also removed two directors, who were members of the special committee and supported the Hometown liquidation, leaving just one director on the special committee. Lampert’s actions successfully blocked the Hometown liquidation. Believing that a deal with Lampert was the only path forward, the board, through the special committee, negotiated a transaction that resulted in Lampert cashing out the remaining minority stockholders.

One of the minority stockholders filed suit against Lampert for breach of his fiduciary duties as a controlling stockholder. The Court found that Lampert did not breach his fiduciary duties when he exercised his voting power to amend the bylaws and remove the two directors, but that the transaction was not entirely fair.

The Decision

Controllers owe limited fiduciary duties when exercising their voting rights

The Court began its analysis by noting that a controlling stockholder is not prohibited by law from using its voting power to prevent board action.⁵ Examining precedents, the Court explained that a controlling stockholder does not have fiduciary duties towards a corporation and its stockholders when voting to maintain the status quo.⁶ Accordingly, a controlling stockholder faces no liability by “refus[ing] to vote in favor of, or affirmatively vot[ing] against,” a transaction that would change the status quo, even if that transaction is in the best interest of the company.

But when wielding voting power to “affirmatively change the status quo,” the Court held a controller owes (1) a duty of loyalty that forbids the controller from intentionally harming the corporation or minority stockholders, and (2) a duty of care that requires the controller to avoid harm to the corporation or minority through gross negligence.⁷ The Court further distinguished the duties of a controlling stockholder from those of a director, explaining that while a director has an affirmative duty to protect the interests of a corporation, a controlling stockholder has no such duty.⁸

Enhanced scrutiny may apply to controlling stockholders exercising their voting power to change the status quo

Vice Chancellor Laster highlighted that this case raised difficult corporate governance questions and noted the tension between a controller’s voting rights and its fiduciary duties as a controlling stockholder. Although Delaware courts have reviewed a director’s actions for situational conflicts or invasion of an area “reserved for stockholders,”⁹ the Court had never opined on the obverse. In this instance, the Vice Chancellor held that enhanced scrutiny is the appropriate standard of review for two reasons.

First, because enhanced scrutiny applies when directors amend bylaws “or otherwise intervene in elections or voting contests touching on corporate control,” the same standard of review should apply to a controller “when [he] does something comparable.”¹⁰

Second, because bylaws amendments must not be “unreasonable,” and enhanced scrutiny is a test of “reasonableness,” the Vice Chancellor concluded that “applying enhanced scrutiny in this setting does not seem like a big leap.”¹¹

The Court held that Lampert satisfied the requirements of enhanced scrutiny. The Court found Lampert had acted in good faith, after a reasonable investigation, and to achieve a legitimate objective of promoting the “long-term value” of the company. The Court further found that Lampert had identified credible threats associated with the plan to liquidate Hometown. The Court then held that Lampert’s actions, though drastic, were necessary and “sufficiently powerful to neutralize [that] threat,”¹² with Lampert having made a “reasonable choice among debatable tactical alternatives” in response.¹³

The Court’s ruling thus indicates that defensive actions carried out by a controller through its voting power can withstand enhanced scrutiny to the extent that such actions were intended to protect against a perceived threat. Such analysis is common when boards of directors respond to perceived threats through defensive measures.¹⁴

Unresolved, however, is whether a controller’s unilateral exercise of its voting power will always trigger enhanced scrutiny. While the Court used broad language in holding the controller’s actions were subject to review under enhanced scrutiny, the Court was not called upon to address what standard of review should apply when a controller acts without a pending threat to its interests. For example, if on a clear day a controlling stockholder amends the bylaws to require the board to hold multiple meetings and notify stockholders before approving the sale of a significant corporate asset (and where no such sale is being contemplated), that action could be viewed as a governance reform. Accordingly, it remains to be seen whether, in such circumstances, the Court would review the controller’s actions under enhanced scrutiny or the more deferential business judgement rule.

The controller’s acquisition of shares held by the minority stockholders was not entirely fair

The Court held that Lampert’s exercise of voting power to prevent the Hometown liquidation was consistent with his fiduciary duties, explaining that “[i]f nothing else had happened, and if the Company had merely continued operating as it had before the Controller Intervention, then judgment would be entered for the defendants.”¹⁵ However, Lampert’s acquisition of the remaining shares of the Company from its minority stockholders required review under the more exacting entire fairness standard.¹⁶

With respect to fair dealing, the Court was satisfied that neither the timing nor initiation of the transaction raised “fairness issues.” The Court did, however, harbor concerns about how the transaction was negotiated. While a controller may remove a director, the Court concluded that Lampert removing from the three-person committee the two “most visible and vigorous opponents,” and then ceasing any “meaningful negotiations” regarding a sale of Homestead with the one remaining committee member affected the negotiating leverage between the parties and rendered the negotiation process unfair.¹⁷

When measuring what would have been a fair price, the Court distinguished between the Outlet and Hometown segments. Because Lampert acquired Outlet subject to a go-shop provision, and a third party then acquired Outlet after an extensive bidding and sale process, the Court held that this “market-tested price” was “powerful evidence” of Outlet’s fair value.¹⁸

As to Hometown, determining fair value was “more difficult” because its acquisition did not occur subject to a go-shop provision and there was no other evidence of a market-tested price. The Court extensively reviewed various estimates of the segment’s liquidation value, which ranged from $93.9 million to $106.5 million, ultimately adopting Lampert’s risk-adjusted liquidation estimate of $98.41 million as the most persuasive.¹⁹ But the Court rejected Lampert’s position that the liquidation value should be reduced based on the control premium associated with his ownership, finding that Lampert effectively asked the court to apply an unjustified minority discount.

After conducting a sum of the parts analysis that accounted for the sale of Outlet, the valuation of Hometown, net operating loss carryforwards, and Company debt, the Court awarded damages of $1.78 per share, totaling approximately $18.3 million for the class.²⁰

Conclusion

The Court’s Opinion is significant for mapping out the contours of the fiduciary duties a controller owes to minority stockholders when exercising its voting power:

• When simply voting against a proposal that would change the status quo, the controlling stockholder owes no duties.
• When the controller exercises its voting power to change the status quo, it cannot cause harm to the corporation or its minority stockholders through intentional, knowing, or grossly negligent conduct.
• When the controller acts in response to a perceived threat, it must show its perception of the threat and its response were reasonable.
• To be decided in the future is whether a controller’s action to change the status quo, taken on a clear day, likewise warrants enhanced scrutiny or would be reviewed under the business judgment rule.

The authors would like to thank Harnelle St Cloud for her contributions to this OnPoint.

1. No. 2019-0798-JTL, 2024 WL 262322, at *1 (Del. Ch. Jan. 24, 2024).
2. Slip Op. at 11.
3. Id. at 30.
4. Id. at 31-32.
5. Id. at 48-49.
6. Id. at 56.
7. Id. at 60.
8. Id. (relying on Frantz Mfg. Co. v. EAC Indus. Inc., 501 A.2d 401, 409 (Del. 1985)).
9. See, e.g., Unocal Corp. v. Mesa Petroleum Co., 493 A.2d 946, 954–56 (Del. 1985).
10. Id. at 68.
11. Id.
12. Id. at 73.
13. Id. at 74-75 (also noting that Lampert “took action that was less drastic than he might have taken,” such as removing the whole board or installing new directors under his control).
14. See, e.g., Unocal, 493 A.2d 946.
15. Id.
16. Because the transaction was not pre-conditioned on approval by an independent special committee and a majority-of-the-minority stockholder vote, the business judgment rule did not apply. Id. (citing Kahn v. M & F Worldwide Corp., 88 A.3d 635, 645 (Del. 2014).
17. Id. at 109.
18. Id. at 79, 82.
19. Id. at 89-90.
20. Id. at 115-18 (holding Lampert jointly and severally liable with his “entity defendants that a controlling stockholder uses to effectuate a transaction” as “aiders and abettors”).