In Calesa v. American Capital (Feb. 29, 2016), the Delaware Court of Chancery found, at the pleading stage of litigation, that it was reasonably conceivable that American Capital, a private equity firm that was a 26% stockholder in Halt, Inc., was a controller of Halt. Importantly, Vice Chancellor Glasscock based his determination on the affiliations between the Halt directors and American Capital—and not on American Capital’s equity ownership and significant contractual rights set forth in Halt debt owned by American Capital. If the court had not found that American Capital possibly was a controller, the applicable standard of review for the transaction would have been the deferential business judgment rule and, as a result, the case likely would have been dismissed at the pleading stage. With the determination that American Capital may have been a controller, when the case goes to trial, the “entire fairness” standard will apply (under which American Capital and the defendant Halt directors will have the burden of proving that both the price and the process relating to the transaction were fair to the stockholders). Background. According to the plaintiffs’ pleadings, American Capital had refused to provide financing to Halt for a number of years after American Capital’s initial investment in the company. Then, at a time that Halt was in dire financial straits, American Capital offered financing, but Halt rejected it in favor of third party financing on significantly better terms. Soon thereafter, American Capital acquired outstanding Halt debt, thereby obtaining significant veto rights, including the right to block other financings. Later, when the debt held by American Capital was coming due and Halt could not pay it, Halt agreed to a financing by American Capital (on significantly less favorable terms than a third party financing that American Capital had blocked). Through that financing, American Capital obtained a veto right on Halt’s ability to file a voluntary bankruptcy. American Capital then proposed the challenged transaction—a recapitalization of Halt, allegedly as a preliminary step to a sale of Halt. In the recapitalization (the “Transaction”), American Capital’s equity ownership increased to 66% and the interests of the other stockholders were severely diluted. After the Transaction, American Capital did not commence a sale process. Plaintiffs contended that American Capital had never intended to sell Halt and had effected the transaction to “squeeze” the other investors out in order to “seize the value of the company for itself.” Key Points A non-majority stockholder is presumptively not a controller, and contractual rights alone—even if they provide a stockholder with all the negotiating leverage over a company with respect to a transaction involving the stockholder—will not establish control. Fried Frank Private Equity Briefing 2 However, a stockholder’s control of a majority of the board will establish control, even if the stockholder does not have majority equity ownership. Thus, it is important that a stockholder, when designating directors, consider the ramifications of whether an individual would or would not be regarded by the court as “independent”. Contractual rights alone do not establish control. A stockholder that has minority representation on a board and the protection of extensive negative covenants in company debt that it owns should not, based on those factors alone, be viewed by the court as a controller—even if (as was the case for American Capital) the contractual rights provide the stockholder with so much leverage that, as a practical matter, the board and the other stockholders have no alternative but to approve the stockholder’s proposed transaction. It is to be noted, however, that control generally is established based on the totality of the circumstances, and a stockholder’s appointment of directors and/or contractual rights could be relevant in combination with other factors as a foundation for finding control. A majority of the board being controlled will establish control. In Calesa, the court’s determination that American Capital may have been a controller (and therefore may have had fiduciary duties to the other stockholders) was based on the affiliations that a majority of the Halt directors had with American Capital. Quoting his January 29, 2016 Thermopylae decision, Vice Chancellor Glasscock wrote: [A] stockholder who—via majority stock ownership or through control of the board---operates the decision-making machinery of the corporation, is a classic fiduciary; in controlling the company he controls the property of others—he controls the property of the non-controlling stockholders. Conversely, an individual who owns a contractual right, and who exploits that right—even if 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. Bases for the court’s inference that a majority of the board was controlled. In Calesa, although it appeared, based on the plaintiffs’ allegations, that all of the directors may have been not independent and disinterested, the court did not review the independence of the remaining directors once it found that it was “reasonably conceivable” (the standard applicable at the pleading stage of litigation) that a majority of the directors were not independent and disinterested. Personal financial benefit based on American Capital participating in financing the transaction. Notably, the court found it reasonably conceivable that certain directors were not disinterested with respect to the Transaction on the basis that, because they were affiliated with American Capital and American Capital was participating in the financing of the Transaction, they had a “personal financial benefit” relating to the Transaction that was not equally shared by the stockholders. The court emphasized that Halt itself had disclosed, in the materials relating to the Transaction that were provided to the stockholders, that, on this basis, the interest of certain directors was “in addition to or different than” the interest of the other stockholders. The court stated that, given the company’s own statement, the court did not need to resolve, with respect to one of these directors, whether his affiliation with American Capital, as an officer of one of American Capital’s portfolio companies, involved control by American Capital (and the court did not even mention the issue of whether the indirect interest in the financing would be material to him). Loss of job if transaction does not go through. The court also found it reasonably conceivable that the CEO-director was not independent or disinterested, on the basis that he Fried Frank Private Equity Briefing 3 was “beholden” to American Capital for his income and that he would lose his job if the Transaction did not go through. The court noted that American Capital had agreed to the CEO’s continuing in office after the Transaction; and that the board had doubled the CEO’s salary just prior to the Transaction and, in connection with the Transaction, had adopted a management incentive plan primarily so that the CEO would receive 6% of the company’s equity on a sale of the company. The CEO had not always been a controlled director, according to the court, but “became beholden to [American Capital] when [American Capital] became empowered to decide whether [he] would continue to receive material benefits in the form of salary and incentives….” The decision the CEO faced was to “approve the transaction despite what the Plaintiffs allege is the detriment to the unaffiliated stockholders, or see the Company--the source of his income--driven into ruin,” the court stated. Importance of the totality of the circumstances. In Calesa, while the court’s analysis was focused on the affiliations of the directors with American Capital, the circumstances included that: American Capital had appointed, and appeared to have had ongoing strong ties to, all of the directors; American Capital was both Halt’s largest stockholder and its largest debtholder; American Capital had outmaneuvered Halt to the point that, as a practical matter, the Halt board and other stockholders had virtually no alternative but to accept the Transaction; the Halt directors had a history of voting in lockstep in favor of actions that benefitted American Capital, to the detriment of the other stockholders; the Halt directors approved the Transaction in one day, without independent advisors or a fairness opinion; and the Halt directors required that the stockholders’ decide whether to consent to the Transaction within one day after receiving 300 pages of Transaction materials from the board (that were, allegedly, incorrect, missing exhibits, and marked as drafts). Practice Points Consideration of “independence” of director designees. When designating directors, a stockholder should consider the extent to which the designee would be likely to be considered by a court to be independent and to be disinterested in transactions between the stockholder and the company. A stockholder generally will not be considered to be a controller if (a) the stockholder does not have majority equity ownership and (b) a majority of the directors are viewed by the court as independent of the stockholder. A stockholder generally has substantial leeway in designating directors who will be considered independent and disinterested, given that the court has typically—and even more so recently—defined these concepts broadly. It is well established that designation of a director by a stockholder does not, standing alone, render the director nonindependent or interested. Benefits of an independent director on the board. Even if a stockholder designates a majority of directors who are not independent (and thus the stockholder would be considered a controller), in most cases there will still be an advantage to the stockholder in designating at least one independent director. With at least one independent director, the board would have the option, in Fried Frank Private Equity Briefing 4 connection with any transaction with the stockholder, of complying with the MFW prerequisites (approval by a committee of the independent director(s) and by the unaffiliated stockholders) for review of any transaction with the controller under the deferential business judgment rule rather than the more stringent “entire fairness” standard. Moreover, even if the MFW approach is not taken and “entire fairness” will apply, a stockholder’s legal position should be meaningfully enhanced to the extent that the process included review and approval by an independent director (and would be further enhanced if the process included independent advisors, a fairness opinion, and reasonable time periods for board and stockholder consideration). Company disclosure with respect to an interested transaction. In the disclosure to stockholders relating to a transaction with a stockholder, the company should not make a legal conclusion about the independence or disinterestedness of directors. In Calesa, the court’s finding that certain directors were not disinterested was based on the company’s own disclosure that stated that these directors, based on their affiliation with American Capital, had an interest in the Transaction that was “in addition to or different than” the interest of the other stockholders because American Capital would be participating in the financing of the Transaction. Preserving the benefits of a stockholder’s leverage. With respect to a company transaction in which a stockholder has an interest, if the stockholder has a high degree of leverage over the company—whether through equity ownership, debt or other contractual rights, and/or otherwise— the stockholder generally will be in a better legal position to the extent that it utilizes any leverage that it has through rights to veto company actions rather than the leverage it may have with respect to the board. In most cases involving a stockholder with a high degree of leverage, the likelihood that the transaction will be approved will not be reduced, and the stockholder’s legal position will be meaningfully enhanced, if there is a strong board process (as it will either lead to business judgment review, if MFW is complied with, or to a higher likelihood that the transaction will meet the entire fairness test). How a stockholder’s rights (with respect to its equity and/or debt positions) are crafted can affect the risk that it may be deemed to be a controller. A stockholder’s contractual rights (such as negative covenants in debt) will not, standing alone, establish control by the stockholder, as discussed above. However, we note that the dichotomy is not primarily “contractual” versus “equity-based” rights; rather, based on the court’s discussion (although the court did not formulate the analysis in this way), the fundamental issue appears to be whether the rights (a) restrict the company from taking specified action, as opposed to (b) relate to electing or removing directors, or to directing, preventing or restricting the vote of the board or the other stockholders (i.e., rights over the “corporate machinery,” which Vice Chancellor Glasscock has identified as the key to control). Accordingly, rights relating to the board or to the other stockholders—even if contractual in derivation (by being included in preferred stock, debt, stockholder agreements, or other agreements)—could, even standing alone, establish control. Protection against a significant stockholder obtaining extreme leverage through a purchase of company debt. The situation in Calesa (and in the 2014 Comverge case) involved a significant stockholder acquiring an extreme degree of leverage through a purchase of outstanding debt of the company, at a time that the company was in difficult financial straits. With respect to this type of situation: Fried Frank Private Equity Briefing 5 Debt transfer restrictions. When issuing debt, a company should consider whether the debt could include restrictions on sale or transfer of the debt to stockholders with more than a specified percentage of equity ownership (or who have held the equity for less than a specified period). Of course, the impact on the marketability of the debt would have to be considered. Just say no. In addition, as part of a board’s deliberations, the board should consider whether to “just say no” to the stockholder’s proposed transaction. By just saying no, a board may be able to pressure a stockholder that has significant leverage to negotiate. Importance of ensuring that all of the documentation relating to a stockholder written consent is in good order. The court held that the plaintiffs’ allegations that several of the transaction documents provided to the stockholders were incomplete, had missing attachments, or were in draft form were sufficient to state a claim under Section 228 of the Delaware General Corporation Law (which authorizes action by written consent). The court cited past precedent in which the court held that “because Section 228 permits immediate action without prior notice to minority stockholders, actions under Section 228 require strict compliance to avoid mischief and disorder in corporate actions.” Defendants should consider arguing that dilution claims, when made as direct (rather than derivative) claims, should nonetheless be subject to the stricter pleading standards applicable to derivative claims. Noting that claims alleging dilution resulting from a breach of the duty of loyalty benefiting an insider are inherently both direct and derivative in nature, Vice Chancellor Glasscock endorsed the view, which has been previously expressed by the court, that “dual-natured claims” should be addressed under the pleading standard applicable to derivative claims (which requires that the plaintiffs establish that it would have been futile to make demand on the current board to bring the claim on behalf of the corporation). The Vice Chancellor stated in Calesa, as well as in his recent Thermopylae decision, that he did not apply the stricter standard in part because “it would require…review under a particularized pleading standard that neither party has argued is appropriate.” Based on these comments, defendants should consider arguing that a dilution claim that is brought directly should be subject to the stricter standard applicable to derivative claims, based on the inherently dual nature of the claim.