Dubroff, et al. v. Wren Holdings, LLC, et al., Del. Ch., No. 3940-VCN (May 22, 2009), read opinion here.
Kevin Brady, a highly-respected Delaware litigator, provides us with the benefit of his following review of this Delaware Chancery Court decision.
On May 22, 2009, Vice Chancellor Noble granted in part and denied in part defendants’ motion to dismiss a class action involving a contested recapitalization plan that resulted in dilution of equity.
By way of background, the plaintiffs, two former minority shareholders of Nine Systems Corporation (“NSC”), brought a purported class action against NSC and other individuals and entities that included former directors and former shareholders, alleging breaches of fiduciary duties. During 2001 and early 2002, the entity defendants had made a series of loans to NSC. In August 2002, NSC carried out a recapitalization transaction (the “Recap”) by written consent of the holders of a majority of NSC’s stock (primarily the entity defendants) by which the entity defendants converted the preferred debt they each held into preferred stock. Before the Recap, the entity defendants collectively owned 56% of NSC’s stock and after the Recap their holdings increased to almost 80%. The other shareholders’ equity, including the plaintiffs’, decreased from approximately 44% to 22%.
Four years later in November 2006, Akami Technologies announced that it was acquiring NSC. In the NSC proxy statement there was a listing of NSC shareholders as well as the number of NSC shares each held. This was the first time that the plaintiffs became aware of their equity dilution. As a result, the plaintiffs filed suit alleging that the defendants breached fiduciary duties owed to the minority shareholders, and that the individual defendants aided and abetted breaches by the entity defendants. The defendants moved to dismiss the complaint arguing that: (i) the plaintiffs lacked standing to assert their claims because their claims are derivative and the plaintiffs were no longer stockholders of NSC; (ii) the defendants did not fail to disclose material facts; and (iii) the plaintiffs’ claims are barred by the doctrine of laches.
Plaintiffs’ Standing Issue —Direct, Derivative or Both
In his analysis, Vice Chancellor Noble noted that claims regarding corporate overpayment such as in the case of a recapitalization are normally derivative claims because the harm goes solely to the corporation. And under the Delaware Supreme Court’s decision in Lewis v. Anderson, 477 A.2d 1040, 1046 (Del. 1984), for a plaintiff to have standing to assert a derivative claim, the plaintiff must be a stockholder at the time of the alleged wrongdoing and must maintain his/her stockholder status in the corporate entity throughout the litigation. There is, however, an exception to the general rule.
In Gentile v. Rosette, 906 A.2d 91 (Del. 2006), the Delaware Supreme Court held that claims based upon equity dilution can be both direct and derivative in certain circumstances. Vice Chancellor Noble, in quoting Gentile and Tooley v. Donaldson, Lufkin & Jenrette, Inc., 845 A.2d 1031 (Del. 2004) noted that:
[a] breach of fiduciary duty claim having this dual nature arises where: (1) a stockholder having majority or effective control causes the corporation to issue “excessive” shares of its stock in exchange for assets of the controlling stockholder that have a lesser value; and (2) the exchange causes an increase in the percentage of the outstanding owned by the controlling stockholder, and a corresponding decrease in the share percentage owned by the public (minority) shareholders.
Thus, under Gentile and its progeny, “where a controlling shareholder causes the corporate entity to issue more equity to the controlling shareholder at the expense of the minority shareholders,” the shareholder’s claim can be both derivative and direct.
In this case, the plaintiffs lost their standing to bring derivative claims because they lost their stockholder status when NSC was acquired by Akami Technologies. In an effort to couch their claim as a direct claim under Gentile, the plaintiffs tried to show that the entity defendants collectively formed a controlling shareholder group. Unfortunately for the plaintiffs, the Court found that their claims under Gentile failed as a matter of law because “the Complaint states in conclusory fashion that the [e]ntity [d]efendants ‘controlled the NSC board of directors,’ but the Complaint is devoid of any facts demonstrating an agreement or that the [d]efendants were tied together in some legally significant way”. Moreover, in what might have been the death knell for plaintiffs on this issue, at the hearing on the motion to dismiss, “the plaintiffs conceded that there were no facts in the Complaint from which the Court could infer that an agreement existed”. As a result of a lack of standing to bring a direct claim, Vice Chancellor Noble granted defendants’ motion to dismiss the substantive claim regarding the Recap.
The Disclosure Claims
The plaintiffs also challenged the sufficiency of the notice sent to inform them of the Recap. Because the Recap was accomplished by written consent of the majority stockholders, there was neither a vote nor a solicitation of the plaintiffs’ approval. While the Court noted that “Delaware case law has not addressed the question of whether the notice required by 8 Del. C. § 228(e) triggers a fulsome disclosure akin to that required when stockholder approval is being solicited”, he did not need to address that issue here because the plaintiffs had stated a claim for breach of fiduciary duty so the motion to dismiss the disclosure claims was denied.
Finally, the defendants claimed that the plaintiffs’ claims were barred by the doctrine of laches because they were on “inquiry notice” that interested parties converted their shares long before the plaintiffs brought their action. The Court rejected this argument, however, because the plaintiffs were not told that about the dilution until years after the notice was sent and the information that the plaintiffs did receive about the Recap informed them that “senior debt converted in the Recapitalization ‘was raised from existing investors.’” The defendants did not inform them that the “existing investors” were also members of NSC’s board of directors.