Delaware courts have recently had the opportunity to evaluate and discuss management of potential conflicts. That guidance may be particularly salient in the context of insider transactions and down-rounds, which may animate potential conflicts and lead to difficult litigation for corporate fiduciaries. This post focuses on guidance gleaned from Delaware cases regarding measures for conflict management at the stockholder level, including the effect of equal treatment or a rights offering, exercise of consent rights, and the use of a disinterested stockholder vote.
Equal Treatment and Rights Offerings
Significant stockholders or groups of stockholders, when alleged to have caused a company to pursue their unique interests, may seek to show that their interests were aligned with those of all other stockholders, or at least that other stockholders had the ability to benefit from a transaction to the same degree, by accepting the same proportionate consideration. Because one way to invoke the entire fairness standard of review is by showing that a controlling stockholder obtained a “unique benefit,” deal planners may seek to eliminate the uniqueness of any benefit to be obtained by a significant stockholder. Delaware courts have largely embraced the proposition that structuring a transaction to provide stockholders with equal consideration can eliminate a conflict arising from controlling stockholder status. Interesting questions regarding such a structure do, however, persist in Delaware litigation.
For instance, in litigation seeking to enjoin the $2.1 billion acquisition of public company Presidio, Inc., Vice Chancellor J. Travis Laster addressed the effect of equal deal consideration on the standard of review applicable to an alleged controlling stockholder transaction. Firefighters’ Pension System of the City of Kansas City, Missouri v. Presidio, Inc., C.A. No. 2019-0839-JTL (Del. Ch. Nov. 5, 2019) (TRANSCRIPT) (“Presidio”) (denying a preliminary injunction following stockholder-plaintiffs’ inspection of books and records pursuant to Section 220). In dicta, the court questioned whether enhanced scrutiny or business judgment was the appropriate standard of review when a controlled company is sold to a third-party buyer. The Delaware Supreme Court has held that Revlon enhanced scrutiny may apply to such a sale because the “situational conflicts that exist in the M&A environment” aren’t necessarily eliminated in a third-party deal. McMullin v. Beran, 765 A.2d 910 (Del. 2000). However, then-Chancellor Leo Strine held, and there seems to be a broad base of acceptance in practice for the premise, that there should be a safe harbor, invoking business judgement deference, for controllers receiving the same deal consideration (in the absence of serious evidence of a conflict of interest). In re Synthes, Inc. S’holder Litig., 50 A.3d 1022 (Del. Ch. 2012); see also GAMCO Asset Management Inc. v. iHeartMedia Inc., C.A. No. 12312-VCS (Del. Ch. Nov. 23, 2016) aff’d No. 593, 2016 D (Del. Oct. 12, 2017) (dividends paid to alleviate a controlling stockholders’ liquidity needs reviewed under business judgment when paid pro rata to all stockholders). In Presidio, the court found that there wasn’t a reasonable probability of success under either standard, and thus did not attempt to resolve any tension between those and other cases, but it highlights an important issue for purposes of both deal planning and deal litigation.
In a transaction where equal consideration is not practicable or may not be readily apparent, such as a financing where stockholders can exercise discretion not to participate, it has been questioned whether some version of equal treatment might nonetheless be established to mitigate the appearance of a conflict. In that context, a broad opportunity to participate in a rights offering has been explored as a method of eliminating a unique benefit arguably enjoyed by a controller or group of insiders. This measure of stockholder-level conflict management spans a wide spectrum of options – e.g., participation could be pro rata of fully diluted capitalization, pro rata of participating stockholders, or some other calculation; or rights could be freely transferrable or within a limited audience. Recent cases shed light on some of these issues while calling into question the idea that a rights offering will necessarily suffice in shifting the standard of review from entire fairness to business judgment.
In Perry v. Sheth, C.A. No. 2020-0024-JTL (Del. Ch. Jan. 17, 2020) (TRANSCRIPT) (“Dealersocket”) (granting directors’ petition for books and records under Section 220(d) of the DGCL), Vice Chancellor Laster addressed whether a rights offering, which was priced at a low valuation, could alleviate the conflict and process issues around the acquisition financing. The court explained that “the equal treatment idea is not a panacea,” and in fact, two forms of disincentives to smaller stockholders may allow a large stockholder to benefit from such a “nominally pro rata offering at a dilutive value.” The first type of disincentive to participation related to minority stockholders’ desire to participate:
The first form is simply “Don’t hit me anymore” and the idea of throwing good money after bad. The minority stockholders are already facing a transaction that they view as oppressive. They’re facing a situation where they think that expropriation is going on. The idea that a stockholder would voluntarily seek to address that by offering the controller, who’s perceived as being abusive, more of their money is counterintuitive.
The court concluded on that basis that the “economic setup, the incentives in a rights offering for the minority are against participation.” The second disincentive to participation related to minority stockholders’ ability to participate:
The second problem is simply that a fiduciary isn’t supposed to put their beneficiary in a position where the beneficiary has to exercise self-help to protect themselves. A fiduciary is actually supposed to be looking out for the beneficiary, not creating a situation where the beneficiary has to act at arm’s length vis-à-vis the fiduciary and exercise self-help for self protection. That leads to a related problem, which is some folks can’t do it. Some folks may not be able to exercise rights in a rights offering to preserve their position. In a nonfiduciary situation, that’s the morals of the marketplace. That’s too bad for the people who aren’t able to participate. But a fiduciary doesn’t get to exploit its beneficiaries simply because its beneficiaries are less well heeled, less well capitalized, less privileged, whatever adjective you want to use.
Returning to the premise that equal treatment may negate the unique benefit and related conflict in a transaction with a significant stockholder, the court stated that “equality can be equity, but equality is not automatically equity. Treatment that is equal in name can be wrongful in fact when those whom you are ostensibly treating equally are themselves different.” The court also found that the process had been hasty with aspects of timing and information flow that seemed to benefit insiders. Although this decision does not bolster an expectation that a rights offering alone can eliminate concerns regarding a conflict, it is a case that could be limited by its factual and procedural context.
The Dealersocket comments on rights offerings may also be read alongside Vice Chancellor Laster’s earlier comments related to a $2.2 billion sale and lease-back of assets by a public company to its newly formed, publicly traded REIT. In re Sears Holdings Corporation Stockholder and Derivative Litigation, Consol. C.A. No. 11081-VCL (Del. Ch. May 9, 2017) (TRANSCRIPT) (approving litigation settlement following stockholder-plaintiffs’ inspection of books and records pursuant to Section 220). In that transaction, the company offered all of its stockholders transferable rights to acquire equity of the REIT in pro rata amounts and on the same pricing as the company’s controlling stockholder. Those public stockholders received a right to acquire REIT Class A stock, while the controller would be investing in REIT Class B stock and another large stockholder would be investing in REIT Class C stock. Although approximately 97 percent of the public stockholders participated in the rights offering, stockholders subsequently alleged that the company had received $300 million less than fair value for the assets, the defendants moved to dismiss, and the parties agreed to settle for a $40 million payment to the company. At the settlement approval, the court did not expound on whether entire fairness or business judgment would have been the applicable standard of review. But the court did note that, because there was very little divergence in the equity holders on either side of the transaction, the harm would have been minimal to none. Based on that observation, this decision may not directly address whether a rights offering can shift the standard of review, but it may demonstrate a model for limiting any damages in a transaction with a controlling stockholder.
Two decisions from 2019 also focused on the stockholders’ ability to participate in a rights offering. More recently, Chancellor Andre Bouchard addressed a $15 million note offering where a group holding a majority of the stock of private company Permian Holdco 1, Inc. and their board affiliates asserted that the pro rata opportunity, offered to stockholders with just over a month to decide, created a safe harbor from the heightened standard of review that would otherwise apply to litigation claims over that conflicted transaction. Strategic Value Opportunities Fund, LP v. Permian Tank & Manufacturing, Inc., C.A. No. 2018-0932-AGB (Del. Ch. Nov. 22, 2019) (TRANSCRIPT) (discovery stayed pending resolution of the motion to dismiss, which was denied in this decision). The court rejected the defendants’ argument after comparing the stockholders’ opportunity to fund their portion of the notes against Delaware precedent where a safe harbor was provided in a pro rata merger, dividend, stock repurchase, and tender offer. In each of those transactions, there were no “barriers to sharing in the benefits offered,” and stockholders could participate without needing to fund their participation. The court assessed the difference between those transactions and a rights offering:
By contrast, the note offering presented potential barriers to participation such that the benefits were not necessarily available to all stockholders as a practical matter. For instance, it is reasonably inferable that some stockholders may not have had sufficient capital available to purchase the note, particularly given the tight time frame under which the note offering was structured.
Earlier in 2019, Vice Chancellor Morgan Zurn addressed similar questions around the structure of a $21 million financing by a private limited liability company, Findly Talent, LLC, which was found as a preliminary matter to have a controlling unit-holder. Quiet Agent, Inc. v. Bala, C.A. No. 10813-VCZ (Del. Ch. Jan. 3, 2019) (“Findly Talent”) (denying a motion to dismiss following pre-trial discovery). In the Findly Talent case, the parties disputed whether the minority unit-holders’ opportunity to participate eliminated any nonratable benefit enjoyed by the controller. The court concluded that, because the minority holders’ participation would not avoid impairment of their rights under the post-financing capital structure, and because the controller was permitted to convert existing bridge notes to participate in the financing without injecting new cash, the controller was receiving a unique benefit, and the entire fairness standard of review would apply to claims that the directors had breached their fiduciary duties.
Deal terms that level the playing field between minority stockholders and a controller should, at the very least, help to show fairness and may aspire to eliminate a unique benefit received by a controlling stockholder. These cases suggest that ease of participation, maintenance of a capital structure approximating the status quo, and transferability of rights are all elements of a rights offering that can improve a transaction from the minority stockholders’ perspective. This does not, however, necessarily equate to a complete set of circumstances that would suffice to shift the standard of review from entire fairness to business judgment with respect to claims over a controlling stockholder conflicted transaction. Similarly, there may be business reasons why rights offerings may not always include these terms: For example, a corporation may have particularly pressing capital needs that give it insufficient negotiating leverage to obtain these terms, or it may have legitimate concerns about competitors owning capital stock or securities laws difficulties that could militate against allowing for the transferability of rights.
Delaware courts have also focused on the presence and use of consent rights in evaluating whether a stockholder has actual control over a company or a particular transaction. Judges have been adamant that negative control and veto rights, standing alone, are unlikely to meet the “actual control” threshold required to confer controller status on a stockholder, but such consent rights have in recent cases factored into a finding that a stockholder had exercised control over a particular transaction. A recent comment from the Court of Chancery has, accordingly, suggested that a waiver of this element of control may provide another measure for managing potential stockholder-level conflicts.
In Voigt v. Metcalf, C.A. No. 2018-0828-JTL (Del. Ch. Feb. 10, 2020) (“NCI Building Systems”) (denying a motion to dismiss following stockholder-plaintiffs’ inspection of books and records pursuant to Section 220), a significant stockholder’s rights under a stockholders agreement factored into the analysis of whether the stockholder was a controller. That stockholder had contractual veto rights over board actions, including with respect to governance matters (e.g., board size changes and bylaw amendments) and corporate and financing transactions. Vice Chancellor Laster specifically noted that the stockholder had not given up its ability to freely vote its shares on those issues. The stockholder “did not give up its contractual rights. Through these rights, [it] enjoyed more stockholder-level authority than a controller that held a majority of the outstanding voting power would possess.” The opinion suggests that sacrifice of or restrictions on such rights could help to show that any control had been mitigated, though that was not part of the holding in this case. We could also imagine that a significant stockholder’s agreement to exercise such consent rights in accordance with a vote of disinterested stockholders or independent directors could also build on this observation from NCI Building Systems that control had been mitigated – and even if such a measure were insufficient on its own, it could arguably soften allegations of actual control.
Submitting a matter to a vote of disinterested stockholders may alleviate some conflict, improve the equities, and even shift the standard of review in litigation. In the absence of a controlling stockholder, where enhanced scrutiny would otherwise apply or half or more of the board is interested in a decision, defendants may still be entitled to business judgment review if the matter is approved by a fully informed, uncoerced vote of disinterested stockholders.
Vice Chancellor Sam Glasscock’s decision in Salladay v. Lev, C.A No. 2019-0048-SG (Del. Ch. Feb. 27, 2020) (“Intersections”) (denying a motion to dismiss complaint based largely on public disclosures) refusing to apply business judgment deference despite the deal’s approval by a majority of the disinterested stockholders highlights the challenges in implementing such a curative measure. The court noted that, in the absence of a controlling stockholder, potential board-level conflicts around the deal could have received business judgment deference if the disinterested stockholder vote had been fully informed and uncoerced. However, plaintiffs successfully alleged that the company’s disclosures produced a vote that was neither uncoerced nor fully-informed. First, the court found that the company failed to sufficiently disclose limits that would apply to the acquirer’s ability to control the board if the stockholders rejected the transaction. The court found that this resulted in both inadequate disclosure and a structurally coercive choice for stockholders between selling their shares and remaining in the company subject to a change of control. Second, the company’s disclosures failed to adequately inform stockholders regarding the circumstances around its decision not to engage a financial adviser that it had engaged in an initial sale process only months before and the decision of another financial adviser to abruptly terminate its engagement after learning the details of the transaction. These issues are valuable in their illustration of structural coercion and the adequacy of technical disclosures.
Disinterested stockholder approval is a powerful tool, further amplified under Corwin v. KKR Financial Holdings LLC, 125 A.3d 304 (Del. 2016) (applying business judgment when a transaction that is not initially subject to entire fairness has been approved by a fully informed, uncoerced majority of the disinterested stockholders), but the Delaware courts have demonstrated that the non-coercion and full disclosure standards are meaningful requirements before defendants can seek “cleansing” of a transaction under a Corwin-style stockholder vote. The recent treatment of these standards is therefore important guidance for deal planners.
Although management of a company occurs at the board level, conflicts at the stockholder level have the potential to ripple through corporate actions and decisions. Those effects of stockholder interests are often relayed through affiliations with directors but can also result from a stockholder’s exercise of power related to governance of the company. The Delaware cases discussed in this post have accordingly explored measures for management of stockholder-level conflicts that focus on the stockholder’s unique interest or ability to affect corporate actions, and we believe that it is through such a lens that potential stockholder conflicts are effectively identified and addressed.
This post comes to us from Nate Emeritz, who is of counsel, and Brian Currie and Jason Schoenberg, who are associates, at the law firm of Wilson Sonsini Goodrich & Rosati, P.C. in Wilmington, Delaware. The views expressed herein are those of the authors and do not necessarily reflect the views of the firm or its clients. This is the second in a series of three articles regarding Delaware case law on board- and stockholder-level measures for managing potential conflicts.