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Chancery Sustains Claims Against Special Committee Members Concerning Stock Incentive Plan

Reith v. Lichtenstein, C.A. No. 2018-0277-MTZ (Del. Ch. June 28, 2019).

As Reith explains, directors may lose the protections of the business judgment rule and expose themselves to liability if they knowingly or deliberately fail to adhere to the terms of a stock incentive plan, such as by violating a clear and unambiguous provision.  And, as Reith illustrates, Delaware courts may consider a company’s prior public disclosures about a plan’s terms in addressing that issue.

In Reith, a stockholder of Steel Connect, Inc. (the “Company”), brought a series of direct and derivative claims in the Delaware Court of Chancery against the Company’s board of directors and Steel Partners Holdings, L.P. (“Steel Holdings”), as its alleged controlling stockholder.  The claims concerned a financing transaction involving a special committee in which the Company issued preferred stock to Steel Holdings that increased its direct ownership from 35.62 percent to 46.76 percent, as well as equity grants to affiliates of Steel Holdings that increased the total beneficial ownership to 52.3 percent.  Defendants moved to dismiss on Rule 23.1 demand-required and Rule 12(b)(6) failure-to-state-a-claim grounds.

Some of the notable issues the Court resolved were whether the plaintiff sufficiently alleged that Steel Holdings was a controlling stockholder, as well as the nature of plaintiff’s claims (direct or derivative, or both).  Reviewing the allegations, the Court found it reasonably conceivable that Steel Holdings was a controlling stockholder with respect to the transaction, given its stock ownership, its ability to appoint directors, its alleged control over management, and its alleged control in connection with developing the transaction.  Addressing whether issuing preferred stock at an unfair price to a controlling stockholder gives rise to a direct or derivative claim under the Tooley test, the Court followed the reasoning of the recent Court of Chancery decision in Klein v. H.I.G. Capital, L.L.C., 2018 WL 6719717 (Del. Ch. 2018) and the Supreme Court’s caution in El Paso Pipeline GP Co., L.L.C., 152 A.3d 1248 (Del. 2016) to find the claim was exclusively derivative.  Specifically, because the preferred stock issuance did not dilute the minority’s percentage of common shares, the claim did not fall within the limited dual-natured direct and derivative exception under Gentile.  The Court applied similar reasoning to determine the equity grants claim likewise was derivative.

Finding the claims derivative, the Court needed to address whether demand was futile under the Aronson test for Rule 23.1 and whether plaintiff otherwise stated a claim under Rule 12(b)(6). The Company’s public SEC filings played an important role in the Court’s decision to sustain most of the plaintiff’s claims.  Regarding the preferred stock issuance, the question under Aronson’s first prong was whether the board was sufficiently independent of Steel Holdings to consider the claims.  The Court found it was not, by a bare majority of the directors, and thus pre-suit demand was excused.  In reaching that conclusion, the Court relied on characterizations in the Company’s SEC filings concerning the pivotal director’s employment with Steel Holdings and its affiliates.  Regarding the equity grants, the Court found demand was excused under both prongs of AronsonAronson’s first prong was satisfied for the same reason as the preferred stock issuance.  Aronson’s second prong was satisfied by the plaintiff’s allegations supporting a knowing or deliberate failure by the board to adhere to the terms of the Company’s stock incentive plan.  In reaching that conclusion, the Court relied on characterizations in the Company’s SEC filings from several years before the challenged grants concerning the plan’s limits. 

Having found demand excused, the Court went on to find adequately pled-claims against Steel Holdings, its affiliated directors, and the non-affiliated directors serving on the special committee.  Regarding the special committee members, although the Court dismissed the claim against them challenging the preferred stock issuance, it upheld the claim challenging the equity grants.  As the Court explained, alleged knowing or deliberate violations of a stockholder approved stock plan implicate non-exculpated breaches of the duty of loyalty, preventing dismissal. 



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