Delaware Supreme Court returns dilutive stock sale case

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The following case should serve as a warning to directors of Delaware corporations when they take steps that may deprive shareholders of their civic rights, especially when electing directors.

The Delaware Supreme Court (the Court) ruled in Marion Coster v. UIP Companies, Inc., No. 49, 2020 (June 28, 2021) that even if an interested board fulfills its obligation to prove that a dilutive share issue is fully fair (Delaware’s most rigorous review standard), a such program may still be subject to legal action. examination for breach of fiduciary duty if it was allegedly approved (i) for unfair reasons or (ii) in good faith but for the primary purpose of interfering with corporate democracy without compelling justification to do so – in which case such a program may be subject to cancellation.

IN DEPTH

The plaintiff in the appeal, Marion Coster (Coster), owned 50% of the shares of UIP Companies, Inc., a Delaware corporation (the Company), with the remaining 50% being held by Steven Schwat, a director of the Company (Schwat). After failing to finalize the terms of a repurchase of Coster shares by Peter Bonnell (Bonnell), an employee and director of the company and a friend of Schwat, Coster called a special meeting of shareholders to elect new directors . The board of directors consisted of Schwat, Bonnell and Stephen Cox (Cox), also an employee of the Company.

Due to equal shareholding, shareholders found themselves in a voting deadlock to elect directors, leaving Schwat, Bonnell and Cox to continue as reserve directors. Coster then asked the Delaware Court of Chancellery to appoint a custodian to break the deadlock, in accordance with 8 Of the. vs. § 226 (a) (1) (action of depositary). As the custodian’s action was pending, Schwat obtained a third-party valuation of the company, which valued the company at $ 123,869, significantly lower than the valuation of approximately $ 4,250,000 awarded during negotiations. acquisition of Coster. The board of directors then approved, by unanimous written consent, a sale of shares to an entity owned by Bonnell, amounting to one-third of all the outstanding shares of the company (the sale of shares), in exchange for $ 41,289.67, thus ending the shareholder deadlock and the cancellation of the custodian’s share. In response, Coster filed a second action to cancel the sale of shares, alleging that the dilutive sale of shares hampered his voting rights and hampered his statutory right to seek the appointment of a custodian by the court.

The Court of Chancery concluded that the sale of shares was significantly motivated by a desire to quash the action of the custodian, but that such reasons were “irrelevant” in considering the sale of shares. The Court held that, given that a majority of the board of directors (Schwat and Connell) was interested in the sale of shares, the only relevant question was whether the defendant had the burden of proving that the sale of actions was entirely fair to Coster in terms of price and process — Delaware’s most onerous review standard. The Court of Chancery ruled that the price was set after a fair (but less than optimal) process and that the price, based on a third party appraisal, was fair. Having determined that the sale of shares was entirely fair, the Court of Chancery refused to accept Coster’s argument that the sale of shares had been approved for unfair reasons or, failing that, in good faith but for the primary purpose of interfering with his voting rights for no compelling reason to do so. The Court of Chancery dismissed the action of the depositary.

On appeal to the court, Coster argued that the Court of Chancery should have considered not only the fairness of the share sale, but also the context in which the share sale occurred — a board of directors. conflicting administration approving a dilutive share issue with the aim of defeating Coster’s decision to vote (and the leverage resulting from the exercise of those rights), entrenching the existing board of directors and interfering with its statutory right to request the appointment by the court of a depositary. The court accepted.

The court held that a ruling that the sale of shares was entirely fair did not terminate judicial review. On the contrary, the Court of Chancellery should have considered Coster’s subsidiary arguments that the board approved the sale of shares for unfair reasons (under the Schnell v. Chris-Craft Indus., Inc., 285 A.2d 437 (Del. 1971) line of jurisprudence) or in good faith but with the primary purpose of interfering with the voting rights and leverage of Coster as an equal shareholder without a compelling reason to do it (under the Blasius Indus., Inc. v. Atlas Corp., 564 A.2d 651 (Del. Ch. 1988) case law).

As the Court explained, Delaware law has long recognized that unfair action does not become admissible simply because it is legally possible. Therefore, the action of the directors affecting the shareholders’ franchise is tested twice, first for legal authorization and then for fairness. Since shareholders’ candor is the ideological foundation upon which the legitimacy of the managerial power of directors rests, Delaware courts will carefully review board actions designed to interfere with the effective exercise of corporate democracy by shareholders. , in particular during the election of directors.

the Schnell Case law holds that directors cannot act to thwart shareholders’ efforts to elect new directors by engaging in transactions designed and pursued with the primary purpose of diluting the votes held by insurgent shareholders. According to the Court, if Coster’s allegations prove to be true – that an interested board of directors approved the sale of shares to deprive his rights as a shareholder and entrench himself in office by thwarting the action of the custodian – under Schnell, the Court of Chancery need not go further to find a breach of a fiduciary duty.

However, under the Blasius case, even if the chamber has acted in good faith (in which case Schnell would not apply), if the sale of shares was approved for the primary purpose of interfering with Coster’s rights as a shareholder, it will survive judicial review only if the board of directors can demonstrate a convincing rationale for their actions.

Accordingly, the decision of the Court of Chancellery that the sale of shares was entirely fair could not substitute for a fairer examination based on Coster’s allegations that an interested board of directors approved the sale of shares to interfere. with his voting rights. The case was remanded for further processing.

Additional remark: In a footnote, the Court explained that it did not consider or rule on whether the “reasonableness and proportionality test” of Unocal Corp. vs. Mesa Petroleum Co., 493 A.2d 946 (Del. 1985) applied in the present case since it had not been discussed by the parties. This may indicate to the parties and to the Court of Chancery that the council may also have to discharge its burden under Unocal a thorough examination given the facts of this case. The Court held in Unocal that when a board’s action is a defensive step taken in response to a threat to company policy and effectiveness that touches on matters of control, the board must prove that such action is proportionate and reasonable in relation to the threat posed. In MM Cos., Inc. v Liquid Audio, Inc., 813 A.2d 1118 (Del. 2003), the Court held that if, in the context of such a hostile struggle for control, the primary objective of the council’s action is to interfere or hinder the effective exercise of the franchise of shareholders in a contested election for directors, then the board, in addition to its burden under Unocal, must first overcome the burden of demonstrating a compelling justification for such an action. This means that in the rare event that Blasius the standard of review applies (rare because an applicant must first demonstrate that the board’s action was primarily intended to deprive shareholders of their voting rights), a convincing rationale should be presented either in a independent, in the absence of a hostile struggle for control, either in the Unocal standard of review when board action is taken defensively (as a prerequisite for any judicial review of reasonableness and proportion).

CARRY

This case was based on specific facts: the Sale of Shares took place after the failure of buyout negotiations between two equal shareholders; the shareholders were deadlocked and the defendants wanted to eliminate the plaintiff’s ability to block shareholder action, including the election of directors, and the leverage that accompanied that blocking power; a majority of the board was interested in selling shares; the sale of shares was to an employee-director who was also friends with the defendant and aligned with the defendant on neutralizing the threat to control of the company, effectively removing the holding board; and the third party valuation of the Company on which the Sale of Shares was based was not requested until after the deposit of the Custodian Share. According to the Court, these facts alone support a finding of breach of fiduciary duty, but the case was remitted to the Court of Chancery for it to draw its own factual findings in light of the Court’s decision. . However, it is less certain that the Court would have reached the same conclusion if the sale were made to an unaffiliated and independent party or if the sale did not directly affect the control of the votes.

Unique facts notwithstanding, this case serves as an important reminder to boards of directors that just because an action is legally admissible does not mean it will avoid fair review by the courts. Boards of directors should be cautious when proposing an action that could interfere with the exercise by a shareholder of their statutory rights, in particular when the facts and circumstances suggest that the main objective of such action is to interfere with corporate democracy or to strengthen the existing board of directors.


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