This post was prepared by Frank Reynolds, who has been following Delaware corporate law, and writing about it for various legal publications, for over 30 years.
The Delaware Court of Chancery recently ruled that SmileDirectClub Inc. investors did not have derivative standing to charge that their stock value was disloyally devalued by their directors’ excessively-priced insider transaction because it originated before the initial public offering in which plaintiffs became stockholders, in In Re SmileDirectClub Inc. Derivative Litigation, No. 2019-0940-MTZ, opinion issued (Del. Ch. May 28, 2021).
Vice Chancellor Morgan Zurn’s May 28 decision dismissing breach-of-duty charges interpreted a key Delaware Supreme Court opinion on the contemporaneous ownership requirement as saying the challenged insider stock sale must be dated when the SmileDirect board approved it—not when it took effect after the IPO.
The opinion should be a useful guide for determining derivative standing, particularly for thorny issues that often arise involving the timing of mergers and stock sales. It applies Section 327 of the Delaware General Corporation Law using the state supreme court’s ruling in 7547 Partners v. Beck, 682 A.2d 160 (Del. 1996), to determine when an alleged wrongful act occurred and the Chancery Court’s Leung v. Schuler, 2000 WL 264328 (Del. Ch. Feb. 29, 2000), ruling to decide whether a transaction qualifies as an exception to the Beck rule.
Using that guideline, Vice Chancellor Zurn found that the SmileDirect insider stock sale fit squarely into the Beck category and had little in common with the Leung exception.
SDC, a pioneering direct-to-customer med-tech supplier of discounted orthodontic treatments founded in 2014, decided to reorganize its ownership structure as a Delaware-chartered company in 2019 and disclosed that it would use the proceeds of an IPO to repurchase the earlier investment of six insider directors and their entity allies.
The complaint filed by plaintiffs Kerry Harts and the Doris Shenwick Trust alleged that they were unaware when they bought stock in the SmileDirect’s 2019 IPO that it would be devalued by an insider stock sale that the board had agreed to earlier. The suit charged that the board breached its duty by agreeing to use most of the IPO’s proceeds to pay an “exorbitant price” to purchase the investments.
When the stock price cratered in the days after the IPO because of the prior purchase-price payout, new investors were cheated, plaintiffs said.
No stock, no standing, no suit
The defendants moved to dismiss, arguing that although the stock buy automatically went into effect at the time the IPO provided it with funds, the agreement was inked earlier, when plaintiffs had no stock. The Vice Chancellor agreed, noting that the IPO prospectus clearly disclosed the board’s intention to use up to $808 million of the proceeds to pay for the old SmileDirect stock.
“In Beck, the Delaware Supreme Court held “the timing of the allegedly wrongful transaction must be determined by identifying the wrongful acts which [the plaintiffs] want remedied and which are susceptible of being remedied in a legal tribunal,” the Vice Chancellor said.
But she noted that, “When the plaintiff challenges “the technicality of [a transaction’s] consummation,” rather than the terms of the transaction itself, the Court will measure standing from the time the transaction was completed.”
Nothing like Leung
Plaintiffs argued that, as in Leung, “the wrongful act forming the basis of the derivative claim took place when the [Insider Transactions] w[ere] completed, after Plaintiffs became stockholders,” as “no claim could have arisen until the Company’s intent was manifested despite changed circumstances,” namely the continuously declining stock price and the allegedly undisclosed regulatory challenges that were publicly aired only after the IPO closed”
But the Vice Chancellor ruled that this case bears no resemblance to Leung or any other opinion on Beck exceptions. She said plaintiffs’ primary issue is that the Board:
(1) fixed the Insider Transactions’ price together with the IPO, knowing both prices were inflated; and (2) consummated the Insider Transactions at those prices, even as the market.
Regarding the alleged board agreement to an overpriced insider sale, she said the board, “must have approved or acquiesced in the pricing” before Plaintiffs purchased stock in the IPO because that price “was baked into the IPO, and Plaintiffs were aware of it.”
In granting the motion to dismiss, Vice Chancellor Zurn noted that “this does not mean Plaintiffs are without recourse; it simply means that Plaintiffs do not have the authority to pursue these derivative claims on SDC’s behalf.”