Reis v. Hazelett Strip-Casting Corporation, a recent decision involving a reverse stock split, will be added to a distinguished line of authority providing useful case studies of how not to freeze-out a minority. In the decision, the Court conducted an entire fairness review and held that the transaction was not entirely fair. The decision highlights the potential dangers of implementing a reverse stock split in a coercive manner as a means of squeezing out a minority, without the proper procedural protections.
In 2005, at the time this transaction was initiated, the corporation had a total of 1,150 shares of stock outstanding. Of those, 800 were controlled by Bill Hazelett, and 350 were held by the estate of his deceased brother, Dick Hazelett. Dick’s will directed that the 350 shares be divided among 169 of the corporation’s employees. After the corporation attempted unsuccessfully to purchase the 350 shares from the estate, the board of directors unanimously approved a reverse stock split. The board was comprised of five directors, including Bill and four employees of the corporation, none of whom were independent in the court’s determination. The stock split was subsequently approved at a special meeting of stockholders attended only by the majority stockholder, which was controlled by Bill.
Under the terms of the split, each outstanding share would become a 1/400 factional interest. Thus, after the split, the estate would hold 350/400 of a share. The board did not establish the value of that fractional interest, but resolved generally that the corporation would either arrange for the disposition of the interest or pay the fair value of the interest to the estate in cash. In 2006, the board obtained the opinion of an independent valuation firm that, as of September 2005 when the reserve stock split was approved, each 1/400 fractional interest was worth approximately $1,600. Due to the corporation’s errors in filings with the Delaware Secretary of State, the stock split was not actually effective until 2008. The board did not obtain an updated valuation at that time.
Summary of Court’s Ruling:
Section 242 of the Delaware General Corporation Law authorizes a corporation to implement a reverse stock split via an amendment to its corporate charter. Section 155(2) of the DGCL provides that, in the event a corporation elects to buy out fractional interests in connection with such a transaction, the corporation “shall . . . pay in cash the fair value” of those interests. Section 155(2) does not, however, contemplate a judicial appraisal-style proceeding to determine fair value, as would be the case under Section 262. Instead, under Section 141(a), the corporate board would be responsible for determining such fair value.
After setting forth a concise explanation of Delaware’s three tiers of review for evaluating director decision making, the court concluded that the board’s actions in this case must be reviewed under the most onerous standard, entire fairness. “When a controlling stockholder uses a reverse split to freeze out minority stockholders without any procedural protections, the transaction will be reviewed for entire fairness with the burden of proof on the defendant fiduciaries. [citation omitted] A reverse split under those circumstances is the ‘functional equivalent’ of a cash-out merger.” The court noted that if a stock split were approved by a “duly empowered and properly functioning” special committee, or by a majority-of-the-minority vote of stockholders, the burden of proof would shift to the plaintiffs. The use of both procedural safeguards would allow the transaction to avoid an entire fairness review. Neither procedure was implemented here.
Applying the entire fairness review, the court concluded “[t]here was no dealing in this case that could be called ‘fair.’” The court was persuaded by several facts, including that the lawyer for Dick’s estate was the person who suggested to Bill that the corporation freeze-out the minority shares by using the stock split. As the court wrote, “no one bargained for the minority.” In addition, the controlling stockholder had made threats that the minority would never receive dividends, that the corporation would never pay a higher price than $1,500 per share (which had been determined without aid from any independent source), and that failure to accept that offer might result in the corporation offering selected minority stockholders the substantially reduced price of $990. “Threats of this nature by a controller are evidence of unfairness.”
Ruling on the second prong of the entire fairness review, the Court held that the defendants failed to arrive at a fair price. The court held that “[t]echnically, the defendants did not set any price,” since they did not attempt to determine the fair price of the shares as of the actual time of the reverse split in 2008, and instead used a price that was representative of the price in 2005.
In fashioning a remedy, the court concluded that the case did “not call for a remedy other than an award of fair value.” Vice Chancellor Laster wrote that he was “convinced that the defendants did not set out to extract value rapaciously from the minority, nor did they freeze out the minority to capture the value of opportunities that the corporation was on the verge of achieving and in which the minority otherwise would have shared.” The court determined that a fair price was $3,980 for each fractional interest, relying on capitalized earnings and book value as the appropriate measures for determining the fair value, and rejecting the plaintiff’s comparable companies and capitalized free cash flow methods. The opinion includes a succinct discussion of the application of these measures.