Gentile v. Rossette, C.A. No. 20213-VCN (Del. Ch. May 28, 2010), read Court of Chancery opinion here. Read prior Delaware Supreme Court decision in this case here (ruling that some claims can be both derivative and direct).
This 41-page decision involves the rights and duties of shareholders and directors remaining in the aftermath of a failed commercial venture. The company involved was SinglePoint Financial, Inc. that attempted to develop software as part of the technology boom at the turn of the last century. The majority shareholder, Rossette, was the only source of funding that kept the company afloat during its short and unprofitable existence. Although the company was kept alive long enough to be purchased, within several months of the acquisition, the purchaser filed for bankruptcy and the shares that were received by SinglePoint’s former shareholders as consideration became worthless.
Prior to the sale, however, the majority shareholder and the only other board member decided to improve the balance sheet of the company by converting much of the debt into common stock (the “Debt Conversion”). As a result of the conversion of debt into equity, Rossette’s equity share in SinglePoint increased from 61% to 95%.
The plaintiffs in this case, the former minority shareholders of SinglePoint, challenged that transaction as an improper dilution of their voting and economic rights. The plaintiffs also challenged an option (“the Put Option”) given to Rossette as part of the merger – – an option that was not extended to any other SinglePoint shareholder.
Key Issue Addressed by the Court
Did the directors violate their fiduciary duties to stockholders by approving the Debt Conversion or the Put Option?
Summary of Holding
The Court determined that the Put Option was a right that Rossette could insist on as a creditor. However, the Debt Conversion was not based on his position as a creditor and utilized an unfair process that resulted in a conversion rate that could not be justified. The Court acknowledges that a “proper” conversion rate is at “worst an uncertain undertaking” and in effect the Court is being asked to “engage in alchemy – – creating real economic value out of an entity which, with the benefit of hindsight, had little value at any moment in time.”
From the company’s founding in 1996 through the purchase via merger in the year 2000, the company was funded almost entirely by its majority shareholder, Rossette. At the time of the merger, Rossette was either unwilling or unable to continue to fund the operations of the company which to that point had not been profitable
Importantly, without the merger, it is unlikely that the company could have survived beyond the Fall of the year 2000.
The contention of the plaintiff is that the Debt Conversion and the Put Option were unfair to them and that the burden to prove their entire fairness should be imposed upon the defendants. They seek damages measured by the sum of the value of the excess shares issued to Rossette as a result of the low conversation rate, plus the value of the Put Option.
Defendants on the other hand, argue that without the financial assistance of Rossette, there would never have been a SinglePoint in existence, which would have obviated any Debt Conversion or merger. The defendant directors argue that with such a small and financially fragile company, the fiduciary duty arguments need to be seen in context. Moreover, they rely on the exculpatory provision in the charter pursuant to Section 102(b)(7) that, they argue, should relieve them of liability from money damages.
The Court regarded the facts as demonstrating a “classic example of self-dealing by a controlling shareholder”, due to the ability of Rossette to determine the price of the Debt Conversion for his own benefit. There was only one other member of the board, who may have been independent, but he failed to follow the necessary procedure that would have provided him with the benefit of his independence as follows: (1) He was not acting as a one-member special committee (however inadvisable such a one-member committee would be) (see footnote 36); (2) He received no independent legal or financial guidance; (3) There was no information on which he relied to determine what a fair conversion price would have been; (4) There was no fairness opinion to support the pricing; and (5) When only one member of a two-person board is independent, the board is not considered independent and disinterested. Thus, under the circumstances, the burden of justifying the Debt Conversion falls upon the directors under the entire fairness standard. See footnote 39.
The Court’s reasoning about why the process used to arrive at the Debt Conversion pricing was unfair was based on the same reasons that support the conclusion of the Court that the sole independent director did not cleanse the taint of the self-interested conduct of Rossette. Likewise, from a tainted process, one should not be surprised if a tainted price emerges. Much of the Court’s 41-page decision is devoted to an analysis of the failure to satisfy the fair price component of the entire fairness standard.
Calculation of Damages
After determining that the Debt Conversion was not fair to the minority stockholders as a matter of price and process, the framework for the remedy was as follows: “The only remedy available would be damages, equal to the fair value of the shares representing the overpayment by the company in the Debt Conversion.” See footnote 57. [See also prior decisions of the Court on Summary Judgment: Gentile v. Rossette, 2005 WL 2810683 (Del. Ch. Oct. 20, 2005, rev’d on other grounds, 906 A.2d 91 (Del. 2006)).]
After providing almost two-pages of itemization and tables, the Court arrived at an amount of damages equal to $309,000.
Personal Liability of Directors
The sole independent director invoked the provisions of the company charter that would exculpate him from liability from money damages caused by his breach of fiduciary duty as long as he acted neither disloyally nor in bad faith. See footnote 60. The Court noted, however, at footnote 62, that Rossette could not enjoy the exculpation provisions under Section 102(b)(7) because as a controlling shareholder who used his position to enter into the Debt Conversion for his personal benefit, his liability was the result of a breach of the fiduciary duty of loyalty and the exculpation clause provides him no relief for such a breach.
However, the Court determined that the sole independent director was entitled to the protection of the exculpatory provision for the following reasons: (1) He received no personal benefit; (2) The dilutive effects of the Debt Conversion injured him more than anyone else; (3) He tried to do the best he could in the difficult circumstances; (4) His ability to discharge his duties was limited by his lack of experience as a director and lack of resources to obtain independent advice; and most importantly, (5) At most he breached his fiduciary duty of care, but he demonstrated that he otherwise acted loyally and in good faith and therefore, may not be held liable for money damages. See footnote 61.
In contrast, the Court reasoned that the Put Option was insisted on by the purchaser and caused a substantial detriment to Rossette and no benefit. Thus, the Put Option as a provision in the merger transaction was entirely fair to the shareholders of the company and would not be the basis of liability.
It is noteworthy, in closing, that the long-suffering controlling shareholder who appeared to put most of his life savings into this startup company to keep it alive during its entire short and unhappy existence, apparently lost most of those life savings when the purchaser of the company whose shares were used as consideration for the purchase, filed bankruptcy soon after the purchase via merger. Thus, in addition to suffering a substantial loss after funding the company during its short existence in order to avert the likelihood of bankruptcy, the majority shareholder now suffers the ignominy and the further financial pain of this decision that despite the money he lost to keep the startup company afloat, he did not comply with the applicable legal requirements. Who said life was fair.