On February 29, 2016, the Delaware Court of Chancery denied a motion to dismiss fiduciary duty claims against certain current and former directors of Halt Medical and a 26% stockholder, American Capital, arising out of a transaction that was allegedly designed to “squeeze out” minority stockholders.  See Calesa Associates, L.P. v. American Capital, Ltd., C.A. No. 10557-VCG.  Vice Chancellor Glasscock found that the plaintiffs had adequately alleged that American, despite owning only 26% of the company’s shares, exercised sufficient influence over the Halt Medical board such that it and certain affiliates could be deemed “controlling stockholders” owing fiduciary duties to other stockholders.  Among other things, the decision in Calesa reaffirmed that majority stock ownership is not the sole criterion for determining “control.”  The decision also sounded a cautionary note, however, by suggesting that, where plaintiffs remain minority stockholders in the company after the allegedly dilutive transaction at issue, they must plead demand futility even where, as here, only direct claims are asserted, or face dismissal at the pleading stage.

Background

Halt Medical was formed to develop procedures and technologies for the treatment of fibroid tumors in women, and according to the plaintiffs, it is “well-positioned to become the standard of care for women in the treatment of fibroid tumors.”  Plaintiffs are minority stockholders in Halt Medical and many also hold company debt or options or warrants on company stock.  Private equity firm American Capital, along with its affiliates, are Halt’s largest shareholders.  At the time of the transaction at issue, they collectively owned 26% of the company’s outstanding common stock and allegedly exercised control over the board by virtue of their influence over four of Halt’s then-six directors.  Through a series of transactions, by 2013 Halt owed American $50 million as evidenced by a note due at the end of 2013 and, in connection with one of these financings, Halt agreed to a “supermajority voting requirement for any future Chapter 11 proceeding.”   Despite prior indications from American that it would extend the note, in September 2013 American demanded payment in full by year end. At that time, the “board launched and conducted a sales process” and sought alternative sources of financing, but those efforts proved unsuccessful.

“Under pressure from the impending due date of the $50 million note,” one of the plaintiff/minority stockholders (Calesa) met with an American-appointed director (O’Brien) to discuss a resolution to the issue, which led to several agreements between Halt and American pursuant to which, among other things, (i) the company would enter into a merger agreement with Halt Merger Sub, and in connection with the merger the company’s preferred stock would be “cancelled and extinguished,” the company’s bylaws and certificate of incorporation would be amended and restated, and Halt’s stockholders would waive any appraisal rights under Delaware law; (ii) the company and its stockholders would enter into a note purchase and share exchange agreement with American pursuant to which American would loan the company up to an additional $73 million, $55 million of which was to be used to repay the existing indebtedness to American; (iii) American would receive a blanket first priority security interest in the company’s assets; (iv) all outstanding warrants to purchase common or preferred stock would be canceled; (v) a management incentive plan would be adopted under which 12% of the proceeds of any subsequent sale of Halt, after repayment of any American debt, would be divided among certain employees; and (vi) the subordinated notes held by minority stockholders would be converted to equity and the preferred stock held by minority stockholders would be canceled if Halt were not sold within one year of the transaction.

The Halt board and the company’s minority stockholders received copies of the 297-page set of transaction documents—which included several incomplete and draft documents as exhibits—just one day before the transaction was scheduled to close and were asked to sign and return them the following day.  The minority stockholders alleged that “the terms recorded in [the] Transaction Documents are significantly different from the deal negotiated by Calesa and O’Brien,” and that they only signed the documents because of the threat that American would demand payment of the $50 million note, which Halt could not pay and “could no longer prevent through a Chapter 11 proceeding.”  The Halt board approved the transaction without holding a board meeting, even though it had not formed a special committee to review the transaction, had not obtained the assistance of a financial advisor or an independent valuation of the transaction, and had not explored other sources of potential financing on more favorable terms to the company.  Following the transaction, American’s equity stake rose to 66% and it held four of Halt’s now-seven board seats.  The plaintiffs alleged that American received a “disproportionate benefit from the Transaction, representing an unfair price to Plaintiffs in light of the substantial contributions made by the minority investors to keep Halt afloat during the preceding years.”  The minority stockholders alleged that American had no real intention of selling Halt, but rather sought instead to maximize and seize the value of the company for itself, and, to that end, cut Halt’s budget, prevented it from commercializing its patented technology, blocked any possibility of a sale until at least 2016, and positioned the company to miss its debt covenants in 2014, all for the purpose of “squeezing out” minority stockholders and “seiz[ing] the value of the Company for itself.”

Vice Chancellor Glasscock denied the motion to dismiss as to American upon finding that plaintiffs had adequately alleged that American was a controlling stockholder standing on both sides of the transaction, thus subjecting the transaction to “entire fairness” review.  The Vice Chancellor also denied the motion as to the director defendants on the ground that plaintiffs had adequately pled that they were not disinterested and independent of American when they approved the challenged transaction.

Takeaways

Failure to plead demand futility is a defense to surviving minority stockholders’ claims of dilution resulting from a breach of the duty of loyalty benefitting an insider.  Citing Gentile v. Rossette, 906 A.2d 91 (Del. 2006) and Carsanaro v. Bloodhound Technologies, Inc., 65 A.3d 618 (Del. Ch. 2013), Vice Chancellor Glasscock noted that “[c]laims alleging dilution resulting from a breach of the duty of loyalty benefitting an insider [have been] recognized as both derivative and direct.”  The reason for the dual treatment in those cases, however, was because the derivative claims in those cases were extinguished by mergers, and thus, “absent direct actions, the breaches of loyalty alleged could never be remedied, an anathema to equity.”  The plaintiffs in Calesa, however, remained stockholders in Halt after the transaction, and therefore could have pursued their claims derivatively.  As the court in In re El Paso Pipeline Partners, L.P. Derivative Litigation, 2015 WL 7758609 (Del. Ch. Dec. 2, 2015) recently held, “Delaware law can and should treat a dual-natured claim as derivative for purposes of Rule 23.1 and the doctrine of demand, but as direct for purposes of determining whether sell-side investors can continue to pursue the claim after a merger.”  Quoting that passage from El Paso with approval, Vice Chancellor Glasscock explained that the plaintiffs should have been required to plead demand futility, which they had not done.  Nonetheless, Vice Chancellor Glasscock declined to dismiss the complaint because neither party contended that the demand futility requirement applied.  However, the Vice Chancellor’s commentary strongly suggests that failure to plead demand futility is a defense to dilution claims where the plaintiffs remain stockholders in the company after the transaction at issue.

The court reaffirmed that there is no pre-determined percentage of equity ownership at which point one becomes a “controlling” stockholder; rather, “control” is a highly fact-specific inquiry that focuses on the stockholder’s actual influence over the board in regard to the transaction at issue.  Citing the court’s decision in In re Crimson Exploration Inc. Stockholders Litigation, 2014 WL 5449419 (Del. Ch. Oct. 24, 2014) (previously discussed here), Vice Chancellor Glasscock reaffirmed that there is “no correlation between the percentage of equity owned and the determination of control status,” and in fact even “‘a large blockholder will not be considered a controlling stockholder unless [it] actually control[s] the board’s decision about the challenged transaction.'”  Vice Chancellor Glasscock found that, although American only held a 26% stake in Halt at the time of the transaction, the plaintiffs had adequately alleged it was a controlling stockholder because the facts suggested that a majority of Halt’s board was under American’s actual control or influence.  That was because three of Halt’s then-six directors had been appointed by American (including one of American’s directors and one of its executives), and a fourth purportedly independent director—a close friend of American’s chairman who co-founded an investment firm that was among American’s largest investors—was appointed at American’s request.

While an alleged controlling stockholder’s appointment of directors does not, by itself, demonstrate that those directors are not independent, courts are likely to find at the pleading stage that such directors are not independent where they also serve on the controlling stockholder’s board and/or have interests that differ from those of the company’s stockholders generally.  Although American’s exercise of its contractual rights to its benefit was not enough to establish that it exercised control over the Halt “corporate machinery,” Vice Chancellor Glasscock found the plaintiffs had adequately alleged that American exercised control over the Halt board because four of the company’s then-six directors were not independent of American.  In particular, the Vice Chancellor found that (i) one director, O’Brien, serves as President, Special Finance and Operations for American and is one of seven American executive officers, and defendants did not dispute his lack of independence; (ii) a second director was a “classic dual fiduciary” because he sat on both American’s and Halt’s boards with duties to both sides in the transaction; (iii) another director, who was CEO of an American portfolio company in which American had invested over $66 million, stood to benefit personally from the transaction in ways not equally shared by the minority stockholders, and was included among the directors identified in the company’s disclosure statement as having “interests that are in addition to or different than the interests of Halt’s Stockholders generally”; and lastly, (iv) Halt’s CEO was faced with the “classic Morton’s Choice” (i.e., two equally bad options) of either voting in favor of the transaction with American to the detriment of the minority stockholders or “see the Company—the source of his income—driven into ruin.”

The exercise of contractual rights by an alleged controlling stockholder is not a basis to find that the stockholder exercises control.  The court rejected as a basis to plead control allegations that American “‘manipulated Halt by promising, then withholding, funding, and acquiring [a third-party note owed by Halt] secured by Halt’s intellectual property in order to force the Halt board to make decisions under duress that were to the detriment’ of the Plaintiffs.”  The court agreed with the defendants that American’s “exercise of contractual rights, alone, are not sufficient to demonstrate control.”  Quoting Thermopylae Capital Partners v. Simbol, Inc., 2016 WL 368170, at *14 (Del. Ch. Jan. 29, 2016), the court instead found that “an individual who owns a contractual right, and who exploits that right—even in a way that forces a reaction by a corporation—is simply exercising his own property rights, not that of others, and is no fiduciary.”

Dual pleading of breach of fiduciary duty and aiding and abetting breach of fiduciary duty against a controlling stockholder is permissible at the pleading stage.  Vice Chancellor Glasscock denied American’s motion to dismiss the aiding and abetting claim against on the ground that the motion was premature.  He explained that, if American is ultimately found to be a controlling stockholder, the aiding and abetting claim would have to be dismissed “for lack of a ‘defendant, who is not a fiduciary.'”  On the other hand, if American is ultimately found not to be a controlling stockholder, the aiding and abetting claim against American could lie.  That determination, Vice Chancellor Glasscock explained, must await a developed record.

Failure to ensure that stockholders whose consent is required have received full, complete and final sets of the transaction documents at issue may render consents invalid under DCGL § 228.  Under DCGL § 242(b)(1), when an amendment to a certificate of incorporation effects a change in stock or stockholder rights, the board is required to adopt a resolution setting forth the proposed amendment and either call a special meeting of stockholders to vote on the amendment or direct that the amendment shall be considered at the next annual stockholders’ meeting.  However, DCGL § 228 provides an exception to this rule whereby stockholders may act “without a meeting, without prior notice and without a vote, if a consent or consents in writing” are signed by the requisite number of stockholders needed to authorize the action voted on.  The plaintiffs argued that the Halt board violated the purpose of § 242(b)(1) by providing them with the 297-page transaction documents just one day before they were required to execute them.  Vice Chancellor Glasscock found no violation of § 242(b)(1) because the Halt board availed itself of § 228’s exception to § 242(b)(1)’s requirement of a meeting by seeking minority stockholders’ signed, written consent.  He did, however, find that the plaintiffs stated a claim under § 228 because some of the exhibits to the transaction agreements were incomplete and/or in draft form, and under Carsanaro, “[w]hen a consent specifically refers to exhibits and incorporates their terms, the plain language of Section 228(a) requires that a stockholder have the exhibits to execute a valid consent.”