Court of Chancery Clarifies Rights of Minority Shareholders Whose Equity is Diluted
The issues addressed in this gem of an opinion include: (i) whether and when a minority shareholder’s claim for breach of fiduciary duty against a control group based on equity dilution is a direct or derivative claim; (ii) whether a disclosure claim regarding a recapitalization plan can proceed despite alleged “inquiry notice” or alleged ratification via a stockholders agreement; (iii) whether the conspiracy theory of jurisdiction applied to several defendants; as well as (iv) unjust enrichment; (v) whether the statute of limitations for individual claims by members of a class action is tolled while the class action is pending; (vi) motions to intervene and consolidate; and (vii) motions to dismiss on several bases, including lack of continuous ownership.
Brief Procedural History and Factual Background
This case involves two sets of plaintiffs both of whom were minority shareholders in Nine Systems Corporation (NSC). The Court referred to the two groups as the Dubroff Plaintiffs and the Fuchs Plaintiffs. In the two prior decisions in this case linked above, the Court dismissed many of the claims of the Dubroff Plaintiffs and also denied class certification, leaving them to pursue individual claims. The Fuchs Plaintiffs had filed a separate suit and they seek to both intervene in the complaint filed by the Dubroff Plaintiffs and consolidate their case with the pending suit filed by the Dubroff Plaintiffs. Defendants filed motions to dismiss the complaint filed by the Fuchs Plaintiffs, a group that includes 43 shareholders each pursuing direct, individual claims.
NSC shareholders representing a majority of the shares (the “Control Group”) approved by written consent a reorganization plan in 2002 that involved a reverse stock split, issuance of new classes of shares and an amendment to the certificate of incorporation (the “Recapitalization”). The net result of the Recapitalization was to increase the percentage of equity ownership of the Control Group and dilute the equity ownership of the minority shareholders. Many of the Fuchs Plaintiffs signed a stockholders agreement in connection with the Recapitalization in which certain disclosures were made (but ultimately, according to this decision, not enough to prevail on a motion to dismiss). The Fuchs Plaintiffs argue that the stockholders agreement does not bar their claims because that agreement was deceptive and failed to reveal certain material terms of the Recapitalization.
Equity Dilution Claim
Several years ago in Gentile v. Rossette, 906 A.2d 91 (Del. 2006), the Delaware Supreme Court established that certain equity dilution claims may be pled both derivatively and directly, although equity dilution claims are typically viewed as derivative under Delaware law. See Feldman v. Cutaia, 956 A.2d 644, 655 (Del. Ch. 2007). Defendants argued that Gentile is inapplicable because some of the Fuchs Plaintiffs benefited from the Recapitalization and thus there was not an “exact match” between the controlling shareholder’s increase in ownership and the minority’s decrease in its equity.
The Court criticized the syllogism used by the defendants and even was critical of other Delaware decisions that suggested if anyone other than the controller benefits from the transaction, then the minority may not assert a direct dilution claim. Rather, the Court explained that:
“A corporation’s minority shareholders should not be denied a direct equity dilution claim where a controller expropriates, from them, a large percentage of the corporation’s equity, keeps most of that expropriated equity for itself, and gives a small amount to other people.”
Relying on the Supreme Court’s opinion in Gatz v. Ponsoldt, 925 A.2d 1265 (Del. 2007), the Court of Chancery in this case reasoned that:
“minority shareholders may have a direct equity dilution claim when their holdings are diluted, and those of the corporation’s controller are not. In other words, as long as the controller’s holdings are not decreased, and the holdings of the minority shareholders are, the latter may have a direct equity dilution claim.”
Fiduciary Duties of Control Group
The Court reiterated well-settled Delaware law that when a control group exists, and it is given controlling shareholder status, its members owe fiduciary duties to the minority shareholders. See n. 24.
The Control Group, as holders of a majority of the stock of NSC, approved the Recapitalization by written consent. DGCL Section 228(e) requires that after a majority approves a transaction by written consent: “prompt notice of the taking of the corporate action without a meeting by less than unanimous consent shall be given to those stockholders…who have not consented in writing….” Neither the notice sent under Section 228(e), nor the notice in the stockholders agreement disclosed either: (i) who benefited from the Recapitalization, or (ii) what benefits they received. The Fuchs Plaintiffs argue that these material omissions prevented them from bringing an earlier action to rescind the Recapitalization.
The Court acknowledged that the precise contours of the disclosure required under DGCL Section 228(e) have not yet been defined under Delaware law, but notwithstanding that lack of guidance, there were sufficient facts pled in this case for the Court to: ”infer reasonably that the board deliberately omitted material information with the goal of misleading the Plaintiffs and other shareholders about the Defendants’ material financial interest in, and benefit conferred by, the Recapitalization not shared with other shareholders.”
Likewise, there was sufficiency in the pleadings for a fiduciary duty claim to proceed on the disclosure issue. See n. 48: “… when directors communicate publicly or directly with shareholders about corporate matters the sine qua non of directors’ fiduciary duty to shareholders is honesty.” (citing Malone v. Brincat, 722 A.2d 5, 10 (Del. 1998)).
Statutes of Limitations for Individual Claims of Class Members
It remains axiomatic that Chancery, as a court of equity, is not strictly bound by the statute of limitations that would otherwise apply to a claim, although absent a tolling of the limitation period they are given great weight. Claims for breach of fiduciary duty are typically subject to a three-year statute of limitations. n. 66. Neither the stockholders agreement nor the subsequent notice of written consent put the shareholders on “inquiry notice” of an alleged self-dealing transaction. The stockholders agreement was not intended as a disclosure document. In addition, as for tolling, the U.S. Supreme Court has interpreted Rule 23 to mean that class members’ individual claims are tolled while a putative class action is pending. n. 76
The Court of Chancery reasoned that a “class action tolling rule makes sense” and announced that rule as Delaware law. Otherwise, the intent of class action litigation–to simplify litigation involving a large number of class members with similar claims–would be defeated, especially if each of them was forced to intervene to preserve their claims.
Motions to Intervene and to Consolidate
A helpful analysis of Court of Chancery Rules 24(a) and 24(b) regarding mandatory and permissive intervention awaits the reader of this opinion. However, the Court determined that instead of intervention, the appropriate approach in this case was consolidation under Rule 42 in order to join the claims of the two sets of plaintiffs. The Court required the parties to submit a form of order to consolidate the related actions.
Conspiracy Theory of Jurisdiction
There was nothing particularly noteworthy about the thorough analysis of the conspiracy theory of personal jurisdiction in this case so I refer the reader interested in that issue to the opinion linked above.