When a Pro Rata Dividend Triggers Entire Fairness
In IRA Trust FBO Bobbie Ahmed v. Crane, Consol. C.A. No. 12742-CB, the Court of Chancery dismissed a stockholder challenge to a reclassification implemented through a pro rata dividend to all stockholders. In addressing the motion to dismiss, the Court saw three key questions: (1) does the entire fairness doctrine apply even though the reclassification involved a pro rata distribution of shares; (2) if entire fairness does apply, does the analytical framework articulated by the Delaware Supreme Court in Kahn v. M&F Worldwide, Corp. (“MFW”) apply to the reclassification; and (3) if MFW applies, have the defendants satisfied its requirements on the face of the pleadings. My colleague, Ed McNally, blogged the other day about the Court’s holding that MFW applied to the challenged reclassification. This blog post focuses on the first question in the Court’s analysis: does the entire fairness doctrine apply to a reclassification implemented by a pro rata distribution of shares.
The issue is important because several companies with well-known founders have implemented capital structures that expand the equity available to the company while permitting the founders to maintain majority-voting control, most notably Facebook, Inc. and Alphabet, Inc., the parent company of Google. In general, the company’s capital needs or, in the case of Facebook, the founder’s personal desire to contribute to charity, drives the need for expanded equity options. Issuing additional stock, however, may cause the founders to lose voting control. One way to avoid the loss of control in these situations is to create a class of non-voting stock that the company or founders can use as currency for acquisitions or donations that will not dilute the founders’ control. Prior to the Court of Chancery’s decision in Crane, no court had addressed the standard of review applicable to one of these reclassifications designed to create additional equity without diluting a controller’s interest but implemented through a pro rata distribution of the new class of stock.
In Crane, NRG Energy, Inc. (“NRG”) owned a majority of the voting power of NRG Yield, Inc. (“Yield”), a company formed to own a portfolio of income producing energy assets from which dividends could be paid to public stockholders. NRG provided Yield management and other services through a contract. In addition, NRG always appointed Yield’s senior management and Yield depended on NRG as a source for income-producing assets. When NRG took Yield public in 2013, NRG held 65% of Yield’s voting power through its ownership of Class B shares. The public stockholders held the remaining voting power in the form of Class A shares.
Yield’s business model required continual acquisition of new income-producing assets which Yield acquired using its Class A shares as currency. By 2014, NRG’s voting control had been diluted to just 55%. In the Fall of 2014, NRG presented several alternatives to the Yield board that would permit Yield to continue to acquire assets without diluting NRG’s voting control. Yield’s CEO and CFO proposed creation of a new Class C stock with no voting rights that could be used for acquisitions. As noted above, the proposal designed to comply with the requirements of the framework of the MFW analysis. After negotiation between the conflicts committee and NRG, the parties agreed that Yield would create two new classes of stock, Class C and Class D, each with 1/100 vote per share, and distribute shares of Class C and Class D stock to holders of then outstanding Class A and Class B shares, respectively, through a stock split (the “Reclassification”). NRG also agreed to make certain additional assets of NRG subject to a right of first refusal in favor of Yield. Before approving the transaction, the conflicts committee’s financial advisor informed the committee that NRG could be diluted below majority voting control by 2015. On May 5, 2015, the Yield stockholders approved the Reclassification. The holders of a majority of the outstanding Class A shares unaffiliated with NRG also approved the Reclassification.
Almost a year-and-a-half later, the plaintiff filed its complaint on behalf of a putative class of Class A stockholders challenging the Reclassification. Addressing the defendants’ motion to dismiss the complaint, the Court first addressed whether the entire fairness standard of review applied. The Court noted that in addition to the traditional forms of “conflict” transactions involving controlling stockholders in the context of a merger or acquisition, in In re EZCorp Inc. Consulting Agreement Derivative Litig., the Court identified additional forms of transactions that are subject to entire fairness review because the controller receives a “non-ratable benefit.” The plaintiff argued that the Reclassification fell into one of these other classes because NRG received the non-ratable benefit of perpetuating its majority control over Yield.
Defendants argued that NRG did not receive a non-ratable benefit for three reasons. The Court rejected them all. First, defendants argued that the Delaware Supreme Court held in Sinclair Oil Corp. v. Levien that entire fairness review does not apply to a pro rata dividend. In Sinclair Oil, however, the Supreme Court warned that it did not agree that the entire fairness test never applied to a dividend declaration. The Court in Crane held that unlike in Sinclair Oil, the well-pled allegations of the complaint showed that the controller did receive something from Yield to the exclusion of the minority: “the means to perpetuate its control position by financing future acquisitions with the low-vote Class C stock authorized in the Reclassification.”
Second, the defendants argued that Delaware courts have applied entire fairness review to pro rata transactions rarely, and under the Delaware Supreme Court’s opinion in Williams v. Geier, the Reclassification does not merit enhanced scrutiny. In Williams, the controller promoted a recapitalization to implement “tenure voting,” where by all shares of stock would have 10 votes per share. Upon sale or transfer a share would revert to one vote per share until held continuously by the same owner for 3 years. The plaintiffs argued the tenure voting scheme entrenched the controlling bloc. On appeal of an order granting defendants partial summary judgment, the Delaware Supreme Court held that on the record there was no evidence to show the controlling bloc would receive a “non-ratable benefit.” By contrast, Crane was at the pleadings stage, which the Court of Chancery found significant, because in Williams the Supreme Court specifically considered the motivations of the board, something that cannot be done without a record.
Third, relying on Yield’s public filings that stated its business plan was premised on a parent-subsidiary relationship with NRG, defendants argued that extension of NRG’s control was not a unique benefit, because stockholders could not reasonably expect that NRG would dilute its control position by voluntary issuances of stock. The Court rejected this argument as well, holding that whatever Yield’s business plan was originally, the plaintiff had pled that NRG was “on the cusp” of losing its control when Yield consummated the Reclassification, which delivered a unique benefit to NRG that the other stockholders did not receive.
Although the Court’s holding in Crane provides a precedent on which plaintiffs can rely to avoid rebut the presumptions of the business judgment rule at the pleadings stage, it does not necessarily spell the death knell for these types of transactions. As the Court’s discussion of Williams indicates, development of a factual record is critical in cases challenging these types of recapitalizations or reclassifications. For example, in its discussion of Williams, the Court in Crane also cited to the transcript of a settlement hearing concerning a similar transaction that Alphabet [Google] undertook to perpetuate the control of that company’s founders. Then-Chancellor Strine noted during the hearing that if Williams applied, “a big part of what the trial [would be] about would be whether the defendants were well-motivated independent directors … who believed [the reclassification] was the right thing for [the company’s] public stockholders.”
Of course, the development of a factual record is unnecessary where, in cases such as Crane, the controller follows the MFW framework. Even if the MFW framework is not followed, Crane highlights the important facts a board must take into account when considering a nominally pro rata transaction that will extend the control of the controlling stockholder. Aside from the headline issue of whether disinterested and independent directors concluded that perpetuation of control was the right thing for the company’s other stockholders, the board should consider other issues, such as the timing of loss of control and alignment of economic interests. For example, in Crane the Court found important for pleading purposes the imminent loss of control even though NRG would maintain a significant economic stake in the company. In the now-withdrawn Facebook recapitalization, however, there was no immediate threat that Mark Zuckerberg would lose voting control, but it was inevitable if he followed through on his announced goal of donating a majority of his wealth. The proposed plan there, however, potentially could have let Mr. Zuckerberg maintain control despite a substantially reduced economic stake in the company. Prior to withdrawal of the proposal, the Court struggled with the appropriate standard of review prior to trial.
The bottom line is that these types of control-perpetuating transactions have multiple facets and require nuanced consideration. Crane tells us that even if entire fairness applies, the MFW framework is available to directors and controllers to shield themselves from liability. Even if it is not available, any advisor to a board considering this type of transaction should read Crane to see the core questions the Court of Chancery expects the board to consider.Share