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Chancery Rejects Attempt to Allege Gentile v. Rossette Direct Claims for Dilutive Preferred Stock Issuances

Silverberg v. Padda, C.A. No. 2017-0250-KSJM (Del. Ch. Sept. 19, 2019).

The Court of Chancery held that plaintiff common stockholders’ fiduciary duty claims challenging the company’s overpayment for dilutive preferred stock issuances were derivative in nature because plaintiffs failed to adequately plead the existence of a controller or control group that benefited at the expense of the minority stockholders.  The Court evaluated the common stockholders’ arguments under the standard set forth by Gentile v. Rossette, 906 A.2d 91 (Del. 2006), which provides that minority stockholders may seek direct relief for dilution claims when a controller or control group benefits at the expense of the minority stockholders’ economic and voting rights.  Gentile requires that a plaintiff plead facts sufficient to establish that a control group’s members are connected in some “legally significant way” and work together toward a shared goal, such as voting or other decision making.  The Court also relied upon Dubroff v. Wren Holdings, which emphasized that the existence of a control group does not require a formal contract, but there must be some indicia of an actual agreement that amounts to more than mere parallel interests among the group members. 

Here, the plaintiffs’ sole basis to show the existence of a preferred stockholder control group was that their respective board representatives, as part of an alleged unspoken quid pro quo, approved rounds of financing that benefited the preferred stockholders to the detriment of the common stockholders.  Because the plaintiffs relied upon nothing more than consistent voting histories to demonstrate the existence of a control group, the Court concluded that the plaintiffs “improperly conflate[d] acts of consensus with the act of forming a group” and held that their claims were derivative and thus subject to demand futility requirements under Rule 23.1.  The Court dismissed most of the plaintiffs’ claims for failure to plead demand futility, and requested supplemental briefing on the issue of whether the remaining claims similarly should be dismissed.