Chancery Dismisses Complaint Challenging Dilution for Lack of Standing and Failure to State a Claim
Hindlin v Gottwald, C.A. No. 2019-0586-JRS (Del. Ch. July 22, 2020)
The plaintiff, a minority investor (“Plaintiff”) in a Delaware limited liability company, Core Nutrition, LLC (the “Company”), brought an action for breach of fiduciary duties and certain provisions of the Company’s LLC agreement (the “LLC Agreement”). The defendants in the action were three individual members of the Company’s board of managers (“Defendants”). Defendants moved to dismiss Plaintiff’s complaint under, inter alia, Court of Chancery Rule 12(b)(6) for failure to state a claim, and 6 Del. C. §§ 18-1001–03 for lack of standing.
After the Company was acquired by an outside entity, the Company notified Plaintiff that he would receive a total consideration of approximately $393,500 in exchange for his units in the Company. Plaintiff, however believed that he was entitled to $2.75 million for his interest. Plaintiff brought this action in the Delaware Court of Chancery, alleging that the discrepancy was a result of actions taken by the Company’s board of managers (the “Board”) which improperly diluted the minority shareholders, breaching Defendants’ fiduciary duties and the covenant of good faith and fair dealing implied within the LLC Agreement. Plaintiff alleged that his conclusion was based on the issuance of “Incentive Units” which were granted prior to the acquisition but to unknown recipients. Plaintiff asserted that Defendants issued these incentive units to themselves which, among other things, resulted in a payout to one of the Defendants exceeding $76 million. Further, the capital balance of the Company at the end of 2017 suggested that the incentive units were not issued for the same consideration at which Plaintiff purchased his units, which Plaintiff suggested also showed an improper dilution.
Describing the complaint as “frustratingly vague,” the Court granted Defendants’ motion to dismiss, holding that the complaint was “devoid of well-pled factual allegations that any of the named Defendants did anything actionably wrong.” The Court first noted that dilution is not per se wrongful, explaining that “[a]s a matter of basic arithmetic, shareholders are diluted every time a company issues new equity.” To survive a motion to dismiss here, Plaintiff needed to adequately allege that the dilution was wrongful, but failed to do so in the complaint. The Court concluded with respect to one defendant, for example, that it could not infer that because a defendant “received more from the Acquisition than [Plaintiff] did,” that the defendant did something wrongful to receive it. The Court likened Plaintiff’s theory to the doctrine of res ipsa loquitor, which it noted could not be reconciled with Delaware’s business judgment rule.
Further, according to the Court, Plaintiff did not adequately allege that the implied covenant of good faith and fair dealing was applicable because he did not allege the existence of a gap in the LLC Agreement sufficient to invoke the doctrine. The Court noted that the doctrine could be invoked only “when the contract is truly silent concerning the matter at hand.” As argued by the Defendants, however, the LLC Agreement addressed the issuance of both Incentive Units specifically, and the issuance of units generally. The Court agreed with Defendant’s analysis that “the Board [was] empowered to issue Incentive Units under the Company’s equity incentive plan” on the plain language of the LLC Agreement. The Court was disinclined to imply anti-dilution protections that the parties could have expressly included if desired.
Lastly, the Court found that Plaintiff lacked standing to bring a breach of fiduciary duty claim because the dilution claim was derivative in nature and Plaintiff was no longer a unitholder of the Company. Pursuant to Delaware law, the Court applied a two-part test to determine whether the claim was direct or derivative, asking: “(1) who suffered the alleged harm (the corporation or the suing stockholders, individually); and (2) who would receive the benefit of any recovery or other remedy (the corporation or the stockholders, individually)?” The Court succinctly noted that dilution claims such as this were “classically derivative” and standing is limited to current shareholders only. The Court also eschewed Plaintiff’s contention that an exception to this rule under Gentile applied, explaining that Gentile allows for dilution claims to be characterized as direct and derivative only when “there is some expropriation of control, in addition to economic value, from minority stockholders.” As Plaintiff had not alleged any such expropriation of control, Gentile did not apply, Plaintiff’s claim was derivative, and Plaintiff did not have standing to pursue the derivative claim because he was no longer a unitholder of the Company. The Court dismissed the action accordingly.Share