To determine the applicable standard of review in a stockholder challenge to a corporate transaction, a plaintiff may rebut the business judgment rule by pleading facts that support a reasonable inference that "a controlling stockholder stands on both sides of a transaction, or at least half of the directors who approved the transaction were not disinterested or independent." If the business judgment rule is rebutted, the most rigorous standard of review, entire fairness, which examines fair dealing and fair price in a transaction, is applicable. A stockholder is deemed a "controlling stockholder," owing fiduciary duties to other stockholders, "if it owns a majority interest in [the corporation] or exercised actual control over the board at the time of the transaction."
In a recent decision, Calesa Associates v. American Capital, C.A. No. 10557-VCG (Del. Ch. Feb. 29, 2016), the Delaware Court of Chancery held that the plaintiff stockholders of Halt Medical Inc. had pleaded sufficient facts to support a reasonable inference that the private equity defendant, American Capital, which owed the largest, but not a majority, equity interest in Halt, was nevertheless its controlling stockholder in a financing transaction between Halt and the alleged controlling stockholder that diluted the interests of other stockholders. The court found that, while not a majority stockholder, American Capital exercised "actual control" over the Halt board's decision in the financing transaction because a majority of the board was beholden to, or not independent from, American Capital. Accordingly, the court concluded that the complaint stated a claim that American Capital was a controlling stockholder, standing on both sides of the financing transaction, which triggered the entire fairness standard of review to the plaintiff stockholders' fiduciary-duty claims against American Capital and the Halt board.
The plaintiff minority stockholders brought fiduciary duty claims against the Halt board and American Capital, challenging Halt's financing transaction with American Capital. Halt is a medical company founded in 2004 to develop treatments for fibroid tumors in women. American Capital was Halt's largest stockholder, owning 26 percent of its equity before the financing transaction. Prior to the financing transaction, minority stockholders had provided bridge funding to Halt, and extended the maturity dates for the bridge loans to permit Halt to continue operations. Through a series of financing transactions, American Capital loaned Halt $50 million under a note, and obtained the right to appoint three directors to Halt's board. But, in contrast to the minority stockholders extending maturity dates for their bridge loans to Halt, American Capital required that Halt comply with the maturity date for repayment of the $50 million note.
After Halt's board exhausted various alternate options for refinancing the note, the board and American Capital eventually agreed to the financing transaction now challenged by the plaintiff stockholders. In the financing transaction, Halt received a $73 million loan from American Capital, of which $50 million was used to repay the prior note owed to American Capital. In return, Halt recapitalized its equity through a merger that resulted in American Capital having a 66 percent equity interest in Halt and the right to designate four of the seven directors on its board. Hence, the financing transaction diluted the other stockholders' equity interest and because American Capital was the largest stockholder, directly affected their stockholder voting interest and attendant control of the board.
In sum, by enforcing its contract right to repayment of the $50 million note, which Halt was unable to repay, and without other financing alternatives, or the ability to seek bankruptcy protection, American Capital allegedly forced Halt's board to accept its financing transaction, through which American Capital became Halt's majority stockholder and obtained control of the majority of its board. While plaintiff stockholders described the financing transaction as a "squeeze out" of minority stockholders, the plaintiffs were still stockholders after the financing transaction was completed—albeit with a significantly diluted equity interest, reduced voting power, and corresponding diminished control of the board and Halt.
Stockholder without Majority Equity Interest
First, as a preliminary matter, the Court of Chancery ruled that even though the dilutive financing transaction allegedly benefiting an insider, American Capital, supported both derivative and direct claims, the failure to plead demand futility was still a defense because the derivative claims were not extinguished by the merger, and instead, the plaintiff stockholders remained stockholders after the financing transaction. But, since the parties did not assert that demand futility was applicable, the court declined to dismiss the complaint based on this defense.
Second, the court found that while not a majority stockholder before the financing transaction, American Capital nevertheless exercised "actual control" over the Halt board's decision to approve the financing transaction. In evaluating whether American Capital was Halt's controlling stockholder, the court determined as a preliminary matter that American Capital's assertion of its contract rights in its note with Halt, which allegedly resulted in pressure on the board's decision to approve the subsequent financing transaction with American Capital, was insufficient alone to demonstrate that American Capital was a controlling stockholder. The court next examined whether a majority of the board was beholden to, or otherwise, not independent or disinterested from, American Capital. Based on the disclosures in the financing transaction, the court found that three of the four directors necessary for a majority of the board were beholden to American Capital based on their affiliations with American Capital and their "interests that [were] in addition to or different than the interests of Halt's stockholders generally." As to Halt's CEO, who was the fourth director needed for a board majority, the court also found that the CEO was beholden to American Capital because he faced a classic "Morton's Fork." He could either vote against the financing transaction that was allegedly detrimental to unaffiliated stockholders, but which vote would result in the collapse of Halt, the loss of his employment, and source of his income; or vote in favor of the financing transaction because his job as CEO, a potential raise, and management incentive plan depended on American Capital's support for Halt to avoid financial collapse.
In sum, because the plaintiff stockholders had pleaded that a majority of Halt's board was beholden to, or not independent from, American Capital, the court ruled that American Capital was Halt's controlling stockholder, and stood on both sides of the financing transaction. Thus, as the controlling stockholder, American Capital owed fiduciary duties to Halt's other stockholders directly, and entire fairness was the applicable standard of review. Accordingly, the court concluded that the plaintiff stockholders had stated a claim against both American Capital and the Halt board for breach of fiduciary duties, and denied defendants' motion to dismiss these claims.
The American Capital decision reaffirms that a majority-equity interest is not the only legal test to determine whether a stockholder is a controller, and that exercising "actual control" over a board's decision in a transaction is also sufficient for a stockholder to be a controller, who owes fiduciary duties directly to other stockholders. A less noticed, but important part of the decision, however, is the court's ruling that a stockholder's mere exercise of its contract rights in a note with the company, which results in pressure on a board's decision in a subsequent financing transaction with the stockholder, is insufficient alone to demonstrate control of the board. Finally, as a point of Chancery practice, although a dilutive financing transaction, benefiting an insider, supports both derivative and direct claims, failure to plead demand futility is still a viable defense when the plaintiff stockholders' derivative claims are not extinguished by a merger, and instead, they remain stockholders after the challenged transaction.