Chancery Addresses Dilution Claim and Duty to Debt Holders

In Re Nine Systems Corporation Shareholders Litigation, Consol., C.A. No. 3940-VCN (Del. Ch. Feb. 28, 2013).

Issues Addressed: (1) Whether a dilution claim could be pursued directly instead of derivatively; and (2) Whether fiduciary duties were owed to debt holders. Answers:  (1) Yes; (2) No.

Short Overview

Prior decisions by the Court of Chancery provide more factual background.  See Dubroff v. Wren Holdings, LLC, 2009 WL 1478697 (Del. Ch. May 22, 2009); Dubroff v. Wren Holdings, LLC, 2011 WL 5137175 (Del. Ch. Oct. 28, 2011) (“Dubroff II”). Highlights of those cases are available on these pages here.

The shareholder plaintiffs were former shareholders of a company which became Nine Systems Corporation, and they were surprised to receive notice in 2006 of a proposal to acquire the company by Akamai Technologies, Inc.  The shareholders objected to self-dealing transactions which, they allege, deprived them of both economic interests and voting power.

In the context of a motion for summary judgment, the claims of unfair dilution of equity and voting power were considered.  The court observed that dilution claims are usually derivative because “dilution causes a corporate harm and the corporation is entitled to a remedy.”  See footnote 42.  For derivative claims that arise before a merger, shareholders typically lose standing to pursue those claims following a merger because of the “continuous ownership rule.”  An exception to that rule was announced by the Delaware Supreme Court in the case of Gentile v. Rossette, 906 A.2d 91 (Del. 2006), which teaches that:  “a derivative claim may also be a direct claim when a controlling shareholder extracts or expropriates the minority shareholders’ economic value and voting power.”  See footnote 44.  Without the application of the Gentile exception, the plaintiffs’ dilution claims would be solely derivative, and because of an intervening acquisition of the company, the claims would be dismissed.

The court explained that a “control group” can be the functional equivalent of a controlling shareholder and cases have described in what context a control group will be deemed to exist.

The court found that for purposes of summary judgment, the control group members acquired the benefits of a substantial increase in their holdings at the expense of the minority shareholders, and at this procedural stage, the court concluded that the claims of the plaintiffs could not be denied the status of direct claims, and therefore, the continuous ownership rule, which only applies to derivative claims, did not require dismissal.

Duties to Debt Holders

The court noted that debt holders are generally owed no fiduciary duty under Delaware law, and that the duties owed by directors to holders of debt instruments does not include a “duty of the broad and exacting nature characterized as a fiduciary duty.”  See footnote 72 and accompanying text.  The court relied on established Delaware law to find that the non-stockholders did not have standing to pursue disclosure claims because those disclosure claims were tied to the dilution claims which they had no capacity to challenge.