Chancery Denies Motion for Summary Judgment on Claims Challenging Unfair Dilution of Shares
Zimmerman v. Crothall, C.A. No. 6001-VCP (Del. Ch. March 5, 2012; revised March 27, 2012).
The issue presented was whether the directors breached their fiduciary duties by issuing shares that they bought themselves and which were not available to the same extent to all shareholders.
Result: The Court of Chancery denied defendant’s motion for summary judgment.
The capital structure of the company involved in this matter was presented in four categories: (1) Class A Common Units; (2) Class B Common Units; (3) Series A Preferred Units; (4) Series B Preferred Units, which participated pari passu with Series A and is Senior to Class A and Class B Common Units. Venture capital investors controlled a majority of the company’s Series A Preferred Units.
The facts indicated that the company over the last few years, as a start-up, generated revenues of less than $1 million in the prior two years, but suffered losses of approximately $5 million during that same period. One of the reasons given for the issuance of several million dollars in additional shares was that there was no other source of financing.
The founder and former CEO challenged the issuances of additional shares claiming that they were self-interested transactions designed to benefit the directors of the company and venture capital sponsors by unfairly diluting its common members. The defendants moved for summary judgment on all counts. Although the Court granted summary judgment to the defendants on the duty of care claims, the Court denied the motion regarding the duty of loyalty claims and found that the defendants failed to establish that the transactions were not self-interested.
After reviewing the familiar standard for summary judgment, the Court also recited the familiar business judgment standard. The Court reiterated the requirement that the plaintiff establish a genuine issue of material fact as the whether the directors were “independent, disinterested, and informed or acting in good faith.” In addition, if a plaintiff meets this burden then the challenged transaction must be reviewed for entire fairness. The fact intensive demands of such review make it difficult for a defendant to prevail on summary judgment. See footnote 21 (citing Encite LLC v. Soni, 2011 WL 5920986, at *20 (Del. Ch. Nov. 28, 2011)).
The Court also observed that in order to rebut the presumption that is a benefit of the business judgment rule’s deference, the plaintiff must show that “the directors’ decision was either wholly-irrational or motivated by self-interest or bad faith on the part of the directors approving the transaction.”
Duty of Care Claims
The plaintiff claimed that the transactions at issue were approved in violation of the duty of due care because they were without deliberation (being approved by written consent), and did not consider all reasonably available information. In connection with its analysis, the Court addressed the use of the word “reckless” in the LLC agreement, and equated the term with the more familiar “gross negligence” standard for breach of the duty of care under Delaware corporate law. See footnotes 29 to 31. The Court explained why it relied on prior Delaware caselaw as opposed to the contract interpretation doctrine known as noscitur a sociis, which refers to the concept of understanding words (and people) based on their companions.
The Court explained in this 51-page decision why summary judgment was appropriate on the duty of care claims. The Court explained that “under the business judgment rule, scrutiny of a board’s actions begins with the presumption that the directors acted on an informed basis, in good faith and in the honest belief that the action taken was in the best interest of the company.” See footnote 36. The Court also emphasized that whether or not the board was reasonably informed in making a business decision does not mean that the board must be informed of every fact, but instead the board is responsible for considering only material facts that are reasonably available at the time of the decision. It is not the office of the Court to second guess the reasonableness and prudence of a business judgment. In order to avoid the application of the rule, plaintiff must allege that “the process applied by a board in making a business decision was so egregious as to constitute reckless indifference to or a deliberate disregard with the whole body of stockholders for actions which are without the bounds of reason.” See footnote 39.
Especially noteworthy is the Court’s instruction that: “where a corporation in financial distress issues stock as a means to raise needed capital, its directors are given considerable latitude in fixing a price for the issuance.” See footnote 47. The Court noted in this case that the defendant failed to present any expert opinion on valuation (which did not help his case).
Duty of Loyalty Claims
The plaintiff claimed that the issuance of additional shares and the approval by the board members who participated in the purchase of those shares was a self-dealing transaction of bad faith. It was also alleged that a majority of the directors stood on both sides of the transaction and received an exclusive benefit at the expense of the common members.
In order to prevail on a bad faith claim, the plaintiff “must overcome the general presumption of good faith by showing that the board’s decision was so egregious or irrational that it could not have been based on a valid assessment of the corporation’s best interests.” See footnote 51. The Court recognized that there is a third “intermediate category” of fiduciary misconduct between subjective bad faith and gross negligence, which is the “intentional dereliction of a known duty.” See footnotes 52 and 53. The Court previously found that the transactions were not grossly negligent or reckless; thus, by necessity it determined that the intermediate standard was not successfully plead.
The entire fairness standard will apply where a transaction is approved by a majority of the directors or a controlling stockholder “standing on both sides of the transaction, dictating its terms, and obtaining a benefit not received by all stockholders generally.” See footnote 53.
In addition to describing those situations in which a shareholder would be deemed controlling, relying on Kahn v. Lynch Communications Systems, Inc., 638 A.2d 1110, 1113 (Del. 1994), the Court found that there was a genuine issue of material fact as to whether or not the venture capital investors together exerted actual control over the company, and therefore the motion for summary judgment on that basis was denied.
The Court found that the majority of the board was either interested or not independent when they approved the challenged transaction. The Court reviewed each individual director defendant to determine whether they were interested and non-independent. See footnotes 65 and 66. After reviewing the definitions as they applied to each member, the Court found that a majority were lacking in independence.
The Court explained that in order to rebut the presumption of director independence, it does not suffice that the directors “moved in the same social circles, attended the same weddings, developed business relationships before joining a board, and describe each other as friends.” Rather, in order to establish lack of independence in considering a corporate transaction, the plaintiff “must make specific allegations of such material connections as financial ties, familial affinity, a particularly close or intimate personal or business affinity, or evidence that in the past the relationship caused the director to act non-independently vis-à-vis an interested director.” See footnote 72.
The Directors Receive an Exclusive Benefit
In addition to showing that a controlling shareholder or a majority of the board was interested, the plaintiff must also show that “a transaction conferred an exclusive benefit on those interested fiduciaries to prove self-dealing.” See footnote 73.
Delaware Supreme Court’s Gentile Decision
The Court reviewed the Delaware Supreme Court’s opinion in Gentile that explained that certain claims can be both derivative and direct in the context of an alleged dilution by controlling stockholder.
The money quote by the Court of Chancery is as follows:
“The essential teaching of Gentile is that in situations where a corporation issues successive shares to a controlling shareholder in exchange for an asset of lesser value, minority shareholders can bring both direct and derivative claims.”
That is, Gentile confirms that two types of actions, direct and derivative, can be brought based on the same transaction.
The Court concluded that the plaintiff properly brought this fiduciary duty claim regarding the alleged overpayments by the company (in connection with the issuance of shares) on at least a derivative basis. In addition, the plaintiff made a sufficient showing to support a reasonable inference that the transaction conferred an exclusive benefit on defendants, namely the opportunity to buy equity in the company at a price that allegedly is unfair.
The Court also emphasized that to the extent that the transaction was not entirely fair, that issue cannot be decided on a summary judgment motion, based on the factual issues presented.
No Pre-emptive Right
The Court acknowledged that there is no inherent right against dilution under Delaware law. The court referred to Section 102(b)(3) of the DGCL which provides that no stockholder shall have the pre-emptive right to subscribe to additional issues of stock unless the charter expressly provides.
In this case, the Court found that the director defendants enjoyed an exclusive benefit under the challenged transactions that was not available to everyone generally, and therefore, the transactions were self-dealing and subject to entire fairness.
DGCL Section 144
The Court explained that DGCL Section 144, when its prerequisites are satisfied, fairly removes an interested director cloud so that an agreement cannot be invalidated solely because the director was involved. However, Section 144, or its analog in the operating agreement in this case, which was based on Section 144, was not intended to address the common law rules for liability or breach of fiduciary duty. Therefore, even if there was compliance, that would not operate as a safe harbor against the challenge to the transaction under the entire fairness standard.
One final note: the Court explained that “where a breach of fiduciary duty claim overlaps completely” a contractual claim that arises from the same nucleus of operative facts, the contractual claim will control and the courts generally dismiss the fiduciary duty claim. See footnote 106.