In the recent decision of In re EZCORP Inc. Consulting Agreement Derivative Litigation, C.A. No. 9962-VCL (Jan. 25, 2016), the Delaware Court of Chancery clarified the standard of review when faced with shareholder challenges to an agreement with an entity affiliated with a common controlling shareholder. The court held that where the corporation did not insulate the questioned transaction through procedural safeguards such as the approval of (a) a committee of independent directors, and (b) a fully informed, non-coerced vote of the unaffiliated shareholders, the court would review the transactions under the strictest level of scrutiny in Delaware’s jurisprudence – the “entire fairness” standard.
In particular, the court held that “[w]hen a transaction involving self-dealing by a controlling shareholder is challenged, the applicable standard of judicial review is entire fairness, with the defendants having the burden of persuasion.” Opinion at 22, quoting Ams. Mining Corp. v. Theriault, 51 A.3d 1213, 1239 (Del. 2012).
Background: Challenged Agreements with an Affiliate of a Controller EZCorp is a publicly traded Delaware corporation. EZCorp has two classes of stock. Defendant Phillip Ean Cohen controls 100 percent of the voting stock, but only a small minority of the issued and outstanding equity of the company. EZCorp entered into agreements in 2011, 2012, and 2013 with defendant Madison Park LLC, a consulting firm controlled by Cohen, to provide advisory services to EZCorp. Madison Park received significant payments pursuant to these arrangements.
Plaintiff, an EZCorp shareholder, filed suit challenging these agreements, alleging that they “were not legitimate contracts for services but rather a means by which Cohen extracted a non-ratable cash return from EZCorp.” Opinion at 10. According to plaintiff, Madison Park was thinly staffed, had no other publicly traded clients, and offered little to no expertise that EZCorp’s own management did not already have.
In addition, plaintiff alleged that in 2014, EZCorp’s audit committee terminated the agreement with Madison Park. In response, Cohen used his voting power to remove the members of the audit committee from EZCorp’s board, and replaced them with directors allegedly loyal to him.
Plaintiff sued, alleging breach of fiduciary duty, waste, aiding and abetting breach of fiduciary duty, and unjust enrichment.
Holding: The Challenged Transactions Deserved Heightened Judicial Scrutiny Vice Chancellor Laster ruled that the strictest standard of scrutiny, the entire fairness standard, governed review of the challenged consulting agreements. The court acknowledged that while “[t]he entire fairness framework clearly governs squeeze-out mergers,” Delaware law has been unsettled on the question of whether this standard applies more broadly to other types of transactions “in which a controller extracts a non-ratable benefit.” Opinion at 24. The court answered this question in the affirmative.
In so holding, the court described at length the “advantages” that it perceived controlling shareholders to have over other stakeholders, including not only minority shareholders, but also unaffiliated directors. Id. at 36. These advantages include control over the flow of information related to issues like compensation and performance, as well as the ability to withdraw support for a director’s re-election, or even to “take the more aggressive step of removing the director,” id. at 38, as allegedly occurred here, with potentially significant financial and reputational consequences for the director personally.
The court also detailed the various ways in which it believed that “[m]anagers and controlling shareholders (insiders) can extract (tunnel) wealth from firms.” Id. at 41. These methods include “cash flow tunneling,” in which the controller (or other insider) “removes a portion of the current year’s cash flow, but does not affect the remaining stock of long-term productive assets,” id. at 42; “asset tunneling,” in which the controller transfers “major long-term (tangible and intangible) assets” to or from the company, often not at market value, id. at 43; and “equity tunneling,” in which the controller “increases [his own] share of the firm’s value, at the expense of minority shareholders, but does not directly change the firm’s productive assets or cash flows.” Id. The court then argued that if a heightened standard of review applied to one form of tunneling – and it appears settled under Delaware law that entire fairness applies to cases involving “equity tunneling” – then it should apply to all forms, not least because controllers are otherwise incentivized to remove value via the method that attracts less judicial scrutiny.
The court emphasized that “it is the controller, not the court, who creates the scenario calling for substantive fairness review.” Id. at 44. The controller could have decided not to issue stock to the public or acquire a majority stake in a publicly traded company. The controller also could have cleansed any suspect transaction through the procedural methods noted above: approval of both (a) a committee of independent directors, and (b) a fully informed, non-coerced vote of the unaffiliated shareholders.
Finally, the court challenged the relevance to this issue of the Delaware Supreme Court’s seminal decision in Aronson v. Lewis, 473 A.2d 805 (Del. 1984), which applied the business judgment rule to transactions similar to those at issue in this case. The court argued that Aronson must be placed in its historical context and limited to the subject of demand futility, which was the issue that Aronson most squarely decided.
The court thus sought to settle this question of Delaware law by holding that the entire fairness standard applies to a review of any transactions with affiliates of controllers. The court acknowledged, however, that “that is the view of just one trial court judge. Ultimately, the choice…is something only the Delaware Supreme Court can resolve.” Opinion at 59.
Importantly, the court took care to note that “in the abstract, there is nothing wrong about a public company hiring a consulting firm to provide services.” Id. at 61. Moreover, the court also held that because in this case EZCorp’s audit committee did approve the agreements, the burden of proof – which under the entire fairness review normally lies with the defendants – could potentially be shifted back to the plaintiff.
Demand Futility Upheld The court also upheld the plaintiff’s contention that demand on EZCorp was excused under the standard set forth in Rales v. Blasband, 634 A.2d 927 (Del. 1993), because there was a reasonable doubt as to whether a majority of EZCorp’s directors “could have properly exercised [their] independent and disinterested business judgment in responding to a demand.” Opinion at 68, quoting Rales, 634 A.2d at 934.
The court analyzed the relevant circumstances and found that six of seven directors lacked such independence. Those included a director who was a senior executive at EZCorp and relied on it for his principal source of income, see Opinion at 71; a director who is a managing director of an EZCorp affiliate also controlled by Cohen, see id. at 74-75; a director who was a “dual fiduciary” of EZCorp and of Madison Park, id. at 76; and a director whose family members were employed by another EZCorp subsidiary, see id. at 78.
Perhaps more strikingly, the court also found that one director lacked independence based on a combination of factors, each of which, standing alone, would admittedly have been an insufficient basis for such a finding. Those factors included the director’s personal participation in the decisions to approve the relevant transactions. While the law is settled that this factor by itself is insufficient, the court pointedly held that “[a] factor that is not sufficiently disqualifying when evaluated alone can still play a role in the overall demand-excusal analysis.” Id. at 82.
The court also cited to “the extensive research on cognitive bias that has developed” to explain why this factor, while not by itself determinative, should be considered more seriously than other cases have suggested. Id. at 83. In addition, the court relied on the fact that Cohen had demonstrated his willingness to remove directors he viewed as disloyal, and the fact that this director was brought out of retirement to serve as a replacement for one of the deposed directors, thus displaying his “apparent eagerness to be of use.” Id. at 84.
Finally, the court also held, with much less analysis, that a director who was EZCorp’s former CEO was also not independent for demand futility purposes, particularly when considered together with “Cohen’s retributive behavior” against disloyal board members. Id. at 90. Thus, for a variety of reasons, the court found that six of EZCorp’s seven directors lacked independence, and therefore that demand was excused as futile.
Conclusion It remains to be seen whether other Delaware decisions will follow EZCorp’s lead and adopt a stricter approach to reviewing transactions other than take-private deals with affiliates of a controlling shareholder. There is reason to believe they may not, particularly since another Vice Chancellor, John W. Noble, took a markedly different approach just seven months earlier in the case of Friedman v. Dolan, C.A. No. 9425-VCN, 2015 WL 4040806 (Del. Ch. June 30, 2015) – a case that Vice Chancellor Laster, in EZCorp, took pains to distinguish. It is also possible thatEZCorp may be limited to cases with egregious allegations, like the controller’s removal of independent directors that was alleged in this case.
Nevertheless, until the law on this point is settled, public companies that have controlling shareholders should exercise enhanced caution when considering consulting agreements or other transactions where the counterparty is also affiliated with the same controlling shareholder.