Stockholders Lack Derivative Standing to Challenge Transactions Whose Terms Were Set Before They Became Stockholders

Morris James LLP

In re SmileDirectClub, Inc., 2021 WL 2182827 (Del. Ch. May 28, 2021)

Under the “contemporaneous ownership rule,” to have standing to bring derivative claims, stockholders in a Delaware corporation must own stock at the time of a challenged transaction. The general rule is that the time of the transaction is when the terms were established, but there are narrow exceptions, such as where the terms were modified and not disclosed, in which case a court may look to when the transaction was consummated. In In re SmileDirectClub, Inc., 2021 WL 2182827 (Del. Ch. May 28, 2021), the Delaware Court of Chancery found that the general rule applied where plaintiffs challenged the terms of a transaction related to an IPO through which they became stockholders.

In connection with its IPO, SmileDirectClub issued a prospectus that disclosed, among other things, the company’s intent to use some of the proceeds of the IPO to finance an insider transaction in which the company would purchase the shares of some pre-IPO investors at the IPO price. Shortly after the IPO, however, the company’s share price dropped, allegedly due to certain undisclosed regulatory and financial challenges. The plaintiffs, who purchased stock and became stockholders as part of the IPO, brought derivative claims for breaches of fiduciary duty against the board of directors, alleging that these challenges were known before the board approved the insider share repurchases at the allegedly inflated IPO price. 

The defendants moved to dismiss on the grounds that the plaintiffs were not stockholders at the time of the relevant transaction and so lacked standing. The defendants argued that, under the general rule, the terms of the insider transaction were established before the IPO and before the plaintiffs became stockholders. The plaintiffs argued that an exception should apply because the declining stock price and regulatory challenges became public knowledge only after the terms of the insider transaction were established. The Court found that inapt, however, because the terms themselves were disclosed as part of the IPO and were not modified. Because the time of the challenged transaction was when the terms were established, a point before the plaintiffs became stockholders, the Court granted the defendants’ motion to dismiss.     

DISCLAIMER: Because of the generality of this update, the information provided herein may not be applicable in all situations and should not be acted upon without specific legal advice based on particular situations.

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