An “allegation that a transaction involves a controlling stockholder who stands on both sides is a serious one because it imposes fiduciary duties on the controlling stockholder and potentially strips directors of the deferential business judgment rule,” see Reith v. Lichtenstein, C.A. No. 2018-0277-MTZ (Del. Ch. 6/28/19). In her recent opinion in Reith, Vice Chancellor Morgan Zurn allowed a derivative complaint to proceed against a minority 35.6% stockholder because the complaint alleged with sufficient particularity that the stockholder exercised actual control in the challenged transactions, subjecting it to entire fairness review. Here the court found that the 35.6% stockholder wielded such formidable voting and managerial power in connection with a preferred stock offering and related equity grants that it was no differently situated than if it had majority control. In so ruling, the court adds Reith to a number of Delaware Court of Chancery decisions that have ruled that a minority stockholder’s exercise of actual control subjects the challenged transaction to entire fairness review.
In addition, the court allowed the equity grant claims to survive against independent directors who served on a special committee for the transaction and approved the grants. Sufficient allegations that the board knowingly or deliberately failed to adhere to the terms of a stock incentive plan when approving the stock grants implicate the duty of loyalty and stated a nonexculpated claim for breach of fiduciary duty.
Steel Holdings and its affiliate (Holdings) in December 2016 owned 35.62% of the stock of Steel Connect Inc. (the company), a Delaware corporation. Holdings had the right to nominate two directors to the company’s board, which it exercised and resulted in the election of two board members affiliated with Holdings, one of whom was the board chair. Holdings was also involved in managing the company by providing services under a management agreement, including treasury, financing, M&A support, advice regarding governance, compliance, public company reporting, litigation and major business transactions. Holdings affiliates served as top company management.
In 2017, Holdings sought a merger transaction that would permit the company to use its NOLs. In August, the company agreed to acquire all the outstanding shares of IWCO, a profitable company providing data-driven marketing solutions.
The financing for the $475.6 million deal was expected to come from Cerberus affiliates and $83.7 million in cash from the company, financed in part through a bridge loan from Holdings. The board formed a special committee to consider the Holdings financing. Eventually, the special committee negotiated and the board approved at a Dec. 15, 2017, meeting, the sale of convertible preferred shares to Holdings for $35 million, which resulted in Holdings’ voting power increasing from 35.6% to 46.7%. At the same December board meeting, the board expanded to seven by adding two new members who were affiliated with Holdings. The board also awarded the two new members of the board and an existing Holdings designee equity grants totaling $12 million for current and future services to the company. Through the equity grants and preferred stock issuance, Holdings and its affiliates increased their beneficial ownership from 35.6% to 52.3%.
Following a Section 220 books-and-records request, the plaintiff filed breach of fiduciary litigation against Holdings and the director defendants, asserting that the preferred stock transaction and equity grants were a pretext to permit Holdings to gain majority control for inadequate consideration, and that the director defendants misled stockholders in seeking approval for the equity grants.
In concluding that Holdings exercised actual control over the company in connection with the challenged transactions, the court focused on the significant size of its 35.6% stock ownership, its ability to appoint company directors and its control over company management. The 35.6% block was a “large enough block of stock to be the dominant force in any contested election.” Through its right to appoint two directors and its clout in successfully obtaining the appointment of five of the eight directors affiliated with Holdings, it effectively controlled the board of directors and disposition of the interests of the unaffiliated stockholders. Finally, the appointment of the company’s top executives who were Holdings affiliates together with the Holdings management agreement enabled it to have “day-to-day managerial supremacy” over the company during the time the challenged transactions were negotiated and approved. These facts sufficiently pleaded “actual control” during the relevant time period causing Holdings to owe fiduciary duties.
Having found that Holdings was a fiduciary on both sides of the transaction and subject to entire fairness review, the court turned to the defendant directors. The court allowed both the preferred stock and equity grant claims to proceed against the Holdings affiliated directors. However, the court dismissed the preferred stock claims against the independent directors who made up the special committee. As independent, disinterested directors, the complaint failed to plead a non-exculpated breach of fiduciary duty claim. The court likely would have also dismissed the equity grant claims against them but for reasonably credible allegations that the board knowingly violated the company’s 2010 incentive award plan in approving the equity grants. Although the independent directors did not benefit from the grant, a knowing or deliberate violation of a stockholder approved stock plan implicates the duty of loyalty which cannot be exculpated. They also were subject to disclosure claims for the misleading disclosures made in connection with the company’s 2017 proxy seeking stockholder approval for the equity grants without disclosing the violation of the 2010 Plan.
Directors always should act in good faith, on an informed basis with care and in the company’s best interests. When affiliated with a dominant or influential minority stockholder involved in a transaction with the company, the stockholder and affiliated management must be particularly mindful of the scrutiny their actions will draw and consider means to neutralize interest or bias. Utilizing an independent special committee, requiring approval by a majority of disinterested stockholders and other devices to assure the fairness of the transaction should be considered. If they do not result in business judgment review, they will at least help the fiduciaries demonstrate the fairness of the transaction if it is challenged.