It is well-settled under Delaware law that in a merger a stockholder loses standing to assert a purely derivative claim. That claim passes instead to the acquiring company. As an asset of a Delaware company, derivative claims should be valued in a merger transaction. Directors of a selling company, however, who fail to value derivative claims and who also bargain for their extinguishment following the merger are at risk of being found to have breached their fiduciary duty.
The Court of Chancery's recent decision in In re Riverstone National Stockholder Litigation, C.A. No. 9796-VCG (Del. Ch. July 28), instructs that a complaint asserting that directors, who faced personal liability on known derivative claims, both attributed no value to the derivative claims and bargained in a merger transaction that the buyer would not assert them, is sufficient to avoid dismissal based on the general rule of post-merger loss of standing, if the stockholder pleads the claims as part of a direct attack on the merger.
The Underlying Transactions
The derivative claim at issue in Riverstone arose from Riverstone National Inc., a fee-based property management company as of 2008, becoming interested after the recession in entering the single-family market instead of the multifamily property market. The plaintiff alleged that Riverstone expended company funds to develop a business plan that would enable it to purchase, lease and then manage the leasing of single-family homes. Following additional company expenditures and interactions with business partners, the plaintiff alleged that Riverstone implemented the plan with others through a Delaware limited partnership, Invitation Homes, that eventually grew to be the largest single-family rental company in the United States. The plaintiff alleged that while Riverstone was never given an opportunity to own an interest in Invitation Homes, the Riverstone board offered that opportunity to certain officers and directors of Riverstone. In exchange for certain deferred capital contributions totaling approximately $4.65 million, three officers and directors received certain limited partnership units of Invitation Homes.
Plaintiffs' Claims of Breach of Fiduciary Duty
When the plaintiff became aware of the above transactions, it sought books and records to investigate potential mismanagement reflected in what the plaintiff alleged to be the Riverstone board's usurpation of a corporate opportunity to invest in Invitation Homes. The plaintiff eventually filed a books-and-records action under Section 220 of the Delaware General Corporation Law. On the same day as that action began, Riverstone agreed to a merger in which all of its issued and outstanding shares of common stock would be converted into the right to receive cash. Although the Riverstone board was aware of the plaintiff's claims of usurpation of corporate opportunity, it gave no value to those claims in the merger and also bargained that the acquirer would release any such claims. The plaintiff claimed the Riverstone board breached its fiduciary duties in connection with the merger by failing to value the derivative claims and by requiring the buyer to agree not to assert the claims post-merger. The defendants moved to dismiss what they characterized as derivative claims on the ground that the plaintiff lost standing to pursue the claims as a result of the merger.
Court of Chancery Rejects Defendants' Claim
The Court of Chancery held that the plaintiff had asserted a "garden variety allegation of director interest, in direct challenge to the merger as unfair." As a consequence the court found irrelevant defendants' argument that the underlying claim of corporate usurpation was derivative and extinguished in the merger. Instead, after determining the plaintiff had adequately alleged a pre-merger claim of corporate usurpation that would have survived a motion to dismiss and that the board was aware of the threatened claim at the time of the merger, the potential liability was material to the directors so threatened, and the board acted through the merger both to eliminate the threat of a derivative action and to eliminate as a matter of contract any future pursuit of the derivative claims post-merger, the court found that plaintiff had adequately alleged that a majority of the directors received a material benefit in the merger not shared by the other stockholders. The court thus concluded that the interested directors bore the burden of proving the entire fairness of the transaction "in light of a plausible allegation of unfair price." In concluding that the Plaintiff adequately alleged unfair price, the court noted that the value of the usurpation claims was approximately 5 percent of the gross value of the merger and 10 percent of the merger consideration net of post-closing adjustments. Stated differently, the court held that "any potential derivative claims have been extinguished; what remains are Plaintiff's allegations that the defendant directors were interested in the merger and that the price was unfair, a direct claim belonging to the plaintiffs."
Riverstone is a reminder that derivative claims against current officers and directors existing pre-merger are corporate assets. This is in addition to those historically derivative claims that arise in the context of a merger and may be deemed to be both direct and derivative at the same time.
If a plaintiff can allege that a majority of the board against whom derivative claims were threatened or pending both failed to value the claims and bargained to preclude their assertion post-merger, then the plaintiff will have alleged an interest and benefit in the merger not shared with the common stockholders. Framed that way the Court of Chancery may find as it did in Riverstone that the plaintiff has adequately pleaded a direct attack on the merger. Such a claim is direct and not derivative and hence the normal rules about the extinguishment of derivative claims in a merger are not applicable. Transaction planners must therefore be careful in merger transactions to assess whether potential derivative claims are material to a majority of the board and if so either to obtain value for the claims or to advise the board that the merger may not act to extinguish the claims, particularly if the interested board also bargains that the acquirer will not assert the claims post-merger. Riverstone provides guidance that there are two ways in which derivative claims can survive a merger (even if indirectly), and transaction attorneys should consider both.