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.
Delaware’s Supreme Court recently reversed the Chancery Court’s refusal to stop a stock sale intended to shift the power balance between rival deadlocked UIP Companies Inc. stockholder factions, finding the sale likely inequitable — although fairly negotiated — if designed to impede investors’ franchise right in Coster v. UIP Companies, Inc., et al., No. 49, 2020 opinion issued (Del. June 28, 2021.)
The en banc high court’s unanimous opinion required the trial court to reconsider its ruling that after the UIP board found the stock sale to the defendant shareholders passed the rigorous entire fairness test they were not required to decide whether it would wrongly tip a 50/50 standoff with plaintiff stockholder Marion Coster. After remand, if the Chancellor decides the board acted for inequitable purposes or in good faith but for the primary purpose of disenfranchisement without a “compelling justification” it should cancel the stock sale, and consider appointing the custodian plaintiff requests, the justices said.
A higher law
While a transaction that is proven to be entirely fair as to price and process may be legal, it could still be inequitable because two seminal state Supreme Court opinions say that under Delaware corporate law, the sanctity of the shareholder franchise tops entire fairness review, Chief Justice Collins Seitz wrote.
The decision will likely be closely studied by corporate law specialists who advise owners and investors in real estate, securities and commodity investment firms which are often recently created, closely held and wracked by contests for control. Notably, the Supreme Court took the occasion to reiterate that “careful judicial scrutiny will be given [to] a situation in which the right to vote for the election of successor directors has been effectively frustrated and denied.”
“As early as Schnell v. Chris-Craft Industries, Inc., 285 A.2d at 439, we recognized that a board of directors could not escape judicial review of its actions by pointing to the legal authorization to undertake a given act” he said, noting that “Delaware law recognizes that the stockholder franchise is the “‘ideological underpinning’ upon which the legitimacy of the directors managerial power rests.:
The Supreme Court, in MM Cos., Inc. v. Liquid Audio, Inc., 813 A.2d 1118 (Del. 2003), later endorsed the standard the Chancery Court used in its ruling in Blasius Industries, Inc. v. Atlas Corp., 564 A.2d 651 (Del. Ch. 1988). Blasius held that, even though Schnell did not apply when the board acts in good faith, if the board nonetheless acts for the primary purpose of impeding stockholders’ franchise rights, the board must prove a “compelling justification” for its actions.
The litigation arose during a deadlock between two 50 percent shareholders of UIP Companies Inc., a Delaware-chartered real estate investment services parent corporation that operated through three subsidiaries and made special purpose entities – high risk, high return investments – a major part of its business. Two of its three founders, Wout Coster and Steve Schwat, each ended up with half of UIP’S stock
After Wout died before the company decided on a value for his stock, his wife, Marion ended up a rival to Schwat and the three-member board.
When the two factions were unable to elect directors, Marion filed suit in Chancery Court seeking the appointment of a custodian to break the deadlock and the Schwat faction countered by selling stock to a board ally. Coster added a suit challenging that motive.
Beside the point?
In her opinion, the Chancellor found that although the directors were conflicted, the price and negotiation of the sale passed the required entire fairness test, so any other considerations – such as the board’s motivation – were “beside the point,” since there was no more demanding test.
On appeal, the high court said, “In our view, the court bypassed a different and necessary judicial review where, as here, an interested board issues stock to interfere with corporate democracy and that stock issuance entrenches the existing board.” It said the Chancellor should have considered whether “the board approved the Stock Sale for inequitable reasons, or in good faith but for the primary purpose of interfering with Coster’s voting rights and leverage as an equal stockholder without a compelling reason to do so.”
May, not must
If the Court of Chancery on remand considers the appointment of a custodian, under 8 Del. C. § 226(a)(1) the court “may”— not “must”— appoint a custodian when deadlock occurs, the justices decided. “The court will have to consider several factors, including whether on a more complete record the appointment of a custodian will breach agreements or otherwise harm the corporation.”