The Delaware Supreme Court decision in Corwin and its progeny established a powerful defense to stockholder challenges of a corporate transaction: in the absence of a controlling stockholder that extracted personal benefits, disinterested stockholder approval of a transaction has the effect of providing review under the irrebuttable business judgement rule. In Garfield v. BlackRock Mortgage Ventures LLC, 2019 WL 7168004 (Del. Ch. Dec. 20, 2019), the plaintiff asserted an entire fairness claim in connection with the Reorganization of a mortgage services company that allegedly involved two stockholders forming a control group that exercised effective control over a Reorganization from which they benefitted. At the pleading stage the Court of Chancery found the allegations of a control group sufficient to preclude a Corwin defense, even though there was no formal agreement between the stockholders or a full alignment of interests.
During the 2008 financial crisis, BlackRock, Inc. and Highfields Capital Management (“HC Partners”) identified a market opportunity to acquire loans from institutions seeking to reduce their mortgage exposures. They formed Private National Mortgage Acceptance Company LLC (“PennyMac LLC”). Identifying themselves as “strategic partners” BlackRock and HC Partners caused PennyMac LLC to form a public REIT in 2019, managed by a PennyMac subsidiary. Later in 2013, the PennyMac CEO, BlackRock and HC Partners took the PennyMac structure public in an Up-C transaction resulting in a new publicly-traded corporation PennyMac Inc. owning PennyMac LLC. The IPO documents issued in connection with the Up-C transaction again referred to BlackRock and HC Partners as “strategic partners” and involved them co-signing a Tax Receivable Agreement.
In 2018 PennyMac’s CEO proposed a Reorganization of the PennyMac capital structure designed to permit the LLC unitholders to exchange tax free their LLC Units for public PennyMac Inc. Class A common stock and thereby receive long-term capital gains treatment on future sales of such stock held for more than one year. The CEO controlling 10.7% of the votes required only the support of BlackRock (controlling 20.1%) and HC partners (controlling 26%) to approve the Reorganization transaction. The Reorganization documents had a provision requiring the consent of BlackRock and HC partners to terminate the Reorganization before its effective date. The Reorganization was approved by the board of directors and stockholders and closed in November 2018.
In this transaction, the PennyMac parties had not implemented the procedural safeguards of MFW to disable a controller’s influence and simulate arms’ length negotiations. They challenged, however, in a motion to dismiss the plaintiff’s allegations that BlackRock and HC partners comprised a control group.
The Court of Chancery first noted that the complaint pled that the two stockholders controlled approximately 46% of PennyMac’s voting stock, enjoyed a unilateral right to block the Reorganization, and each had a right to appoint 2 directors (a total of 4) to the board of directors. Together, the court ruled these facts were sufficient to support an inference that they could exercise transaction-specific control in connection with the Reorganization.
Hence, the court focused on whether there were facts sufficient to infer BlackRock and HC Partners had a “legally sufficient connection” to be considered a control group under the standard applied by the Delaware Supreme Court in Sheldon v. Pinto, 220 A.2d 245, 250-51 (Del. Oct. 4, 2019) (internal quotations and citations omitted):
To demonstrate that a group of stockholders exercises control collectively, the [plaintiff] must establish that they are connected in some legally significant way – such as by contract, common ownership, agreement, or other arrangement – to work together toward a shared goal. To show a legally significant connection, the [plaintiff] must allege that there was more than a mere concurrence of self-interest among certain stockholders. Rather, there must be some indication of an actual agreement, although it need not be formal or written.
Mere concurrence of self-interest is not enough. And here, because the tax consequences of the Reorganization were different for the two investors, they argued mutual self-interest was absent. Moreover, there was no formal or written agreement between the parties to act as a group. But the facts pled showing that they had aligned interests in optimizing the exchange ratio for the LLC unitholders at the expense of the Class A public stockholders and numerous historical and transaction-specific ties were sufficient at the pleading stage for the Court to infer an actual agreement among the two to work together in connection with the Reorganization.
It is unclear whether an MFW approach was considered by the planners of the Reorganization or, if pursued, would likely have resulted in an approved transaction, subject to business judgment review. Where there is a small, influential group of dominant stockholders involved in the management of the corporation who have aligned interests in connection with a specific transaction, careful planning should be given to manage the risk that such stockholders may be seen as acting in concert to control the outcome of the transaction.