Delaware Expands Stockholders' Right to Sue
On March 15, the Delaware Court of Chancery significantly expanded the right of a stockholder to make direct claims against corporate fiduciaries. Previously, many of those claims were classified as derivative claims that could only be brought in the name of the corporate entity. As a result, stricter pleading rules applied and such claims might be dismissed for a variety of other reasons, such as a cash-out merger that denied standing to the plaintiff or a decision by an independent committee to drop the claim on behalf of the entity. Thus, by expanding the number of "direct" compared to "derivative" claims, the decision in Carsanaro v. Bloodhound Technologies, C.A. 7301-VCL (Mar. 15, 2013), expands stockholder rights.
The Bloodhound case involved some fairly common corporate financings of a startup company. Following a series of issuances of preferred stock over several years, the preferred stockholders both took control of the Bloodhound Technologies board of directors and diluted the equity interest of the common stockholders to less than 1 percent of Bloodhound. The controllers then sold Bloodhound through a merger that gave them almost all of the $82.5 million sale price. The plaintiffs who founded Bloodhound and held only common stock received less than $36,000 when their company was sold.
The plaintiffs' complaint alleged that their interests had been wrongly diluted by the defendants' self-dealing and that the merger denied them a fair share of the value of Bloodhound. The defendants sought to dismiss the complaint on several grounds. Most interesting was the defendants' claim that the merger that eliminated the plaintiffs as stockholders had also eliminated their right to sue because they were asserting only derivative claims. Under settled Delaware law, a cash-out merger eliminates a stockholder's right to bring a derivative claim because only a current stockholder may continue to assert a derivative claim. Indeed, a line of Delaware decisions holds that wrongful-dilution claims that assert that the company sold stock for too little belong only to the entity to assert a derivative claim. The Bloodhound plaintiffs would lose their suit if that old law applied.
However, in a detailed analysis, the Delaware Court of Chancery held that the plaintiffs had the right to sue directly for the loss in value they suffered by the dilution and the subsequent merger. Because the plaintiffs did not allege only derivative claims, their complaint survived the defendants' motion to dismiss. In reaching this result, the Court of Chancery may have significantly expanded stockholder rights in two ways.
First, prior dilution claims were generally considered direct and not derivative claims only when a majority or controlling stockholder caused the dilution to benefit himself or herself. At least that seemed to be the holding of the Delaware Supreme Court in Gentile v. Rossette, 906 A.2d 91 (Del. 2006).
The Bloodhound decision effectively removes that "controller" requirement and may permit direct suits for dilution when corporate insiders participate in the dilution of other stockholders' equity. At the very least, when the transaction is not approved by a disinterested and independent board majority, a direct claim may be brought. The key element is whether corporate insiders were in a position to benefit themselves and took that opportunity. Thus, stock issuances to third parties or in an employee compensation plan may still only be challenged in a derivative complaint.
In addition to the typical dilution claim, Bloodhound also expanded the rights of stockholders to attack the terms of a merger they contend has wrongly diverted merger consideration to management. Previously, claims alleging insiders obtained unfair benefits in a merger were often considered derivative claims, at least when the insider benefits did not make the total merger consideration unfair. The prior case law on this issue was, at best, confusing. After a detailed review of those prior decisions, the Bloodhound decision upholds the right of a stockholder to bring a direct claim alleging improper diversion of merger consideration to insiders, even if the total merger price is fair. Hence, such claims may survive the merger. It remains to be seen if all such diversion claims will survive, however. The Bloodhound court was careful to point out that the funds allegedly diverted to management were a substantial part of the total price paid for the company.
In short, the Bloodhound case has more than just a colorful name. It may well change Delaware law by permitting direct stockholder claims that avoid the pitfalls of derivative litigation. While Bloodhound's actual impact will be determined by later cases, it is likely to lead to more litigation alleging insiders have taken for themselves what belongs to all stockholders.