Delaware Supreme Court Rules Dilution Claims Against Controller Are Derivative Only, Shattering Previous Precedent – Corporate / Commercial Law

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United States: Delaware Supreme Court Rules Dilution Claims Against Controller Are Derivative Only, Squeezing Earlier Precedents

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On September 20, 2021, the Delaware Supreme Court made the highly unusual decision to overturn its earlier ruling in Gentile v. Rossette. A precedent often criticized since 2006, Kind created an exception allowing minority shareholders to bring direct and derivative claims in situations where a controlling shareholder allegedly diluted the financial and voting interests of the minority, even though dilution claims were normally considered to be purely derivative. The Delaware Supreme Court has now ruled that such claims are derivative only, and not direct, even when a majority shareholder is involved, thus limiting the ability of minority shareholders to bring such a dilution claim following a merger consummated since, following an acquisition of all shares, minority shareholders generally lose their right to pursue derivative shares. As the Court noted in its decision, determining whether a claim is direct (i.e. owned by the individual shareholder) or derivative (i.e. owned by the company) can therefore be decisive.

Background

The case-Brookfield Asset Management v. Rosson– arose in the context of a private placement in which Brookfield Asset Management (Brookfield) and its affiliates, which controlled the shareholders of TerraForm Power (TerraForm), increased their stake from 51% to 61.5% by acquiring shares additional TerraForm. Subsequently, the minority shareholders filed a class and derivative lawsuit alleging that Brookfield pressured TerraForm to issue its shares in the private placement for inadequate value, diluting both the financial interests and voting rights of the minority shareholders. . Shortly after the filing of the case, Brookfield acquired the remainder of the shares in TerraForm.

Brookfield sought to dismiss the action on the grounds that (1) the plaintiffs’ dilution claims were exclusively derivative because any harm was done to the company, and (2) the plaintiffs no longer had standing to bring derivative claims after the merger. In dismissing the motion to dismiss, the Court of Chancery agreed with Brookfield that the dilution claims were “the epitome of an entity-owned claim” under the test set out in the founding decision of the Delaware Supreme Court in Tooley v. Donaldson, Lufkin and Jenrette because the damage and any recovery were suffered by the company. Nevertheless, the Court of Chancery concluded that the facts fell within an exception created by Kind which allowed both directly and derivative claims should be brought in dilution cases involving a controlling shareholder. In so ruling, the Court of Chancery noted that the result was “unsatisfactory”, but that it was “not free to decide cases in a manner that deviates from the binding precedent of the Supreme Court”. The Court of Chancery allowed Brookfield’s application for certification of an interlocutory appeal.

The Delaware Supreme Court ruling

On appeal, the Delaware Supreme Court unanimously overturned the decision of the Court of Chancery and overturned Kind:

First of all, the Court held that the Kindexclusion in conflict with Tooleysimple two-part test to determine if a claim was derivative or direct. The Tooley the test focuses on (1) who suffered the alleged harm (the company or individual shareholders); and (2) who would benefit from any recovery or other remedy (the company or individual shareholders). To invoke a direct claim under Tooley, a shareholder must demonstrate that the damage suffered by the shareholder was
independent for any harm caused to society. Under the
Tooley test, dilution claims are derived because the harm, in this case, the issuance of shares to a controlling shareholder at an inadequate price flows to the company. Any harm caused to individual shareholders is only indirect through economic dilution and voting power proportional to their stake (and is not independent of the harm caused to the company). By canceling
Kind, the Delaware Supreme Court noted that although
Kind acknowledged that the company was harmed in the event of dilution, it nevertheless erroneously judged that the dilution by the majority shareholders created a separate and direct claim arising from this same transaction. The Court also noted that the
Kind the exclusion erroneously focused on the identity of the perpetrator – the majority shareholder – rather than on the identity of the injured party as required by the
Tooley.

Second, the Court noted that the Kindthe exception was superfluous. Other legal theories have provided shareholders with a basis for direct claims to address breaches of fiduciary duties in the context of the change of control (such as
Revlon claims to maximize the value of a transaction). What’s more, Kind created the potential practical problem of allowing two separate claimants (the company and the individual shareholder) to pursue the exact same recovery.

Third, the Court noted that it did not overturn the case law lightly. On the contrary, more than 15 years had passed since the
Kind decision. At that time, “the practical and analytical difficulties that courts encountered in applying
[Gentile] reflect a fundamental inapplicability. “

Conclusion

Although the Kind ruling created only a narrow exclusion for dilution claims involving majority shareholders, with the recent Delaware Supreme Court ruling overturning
Kind is likely to have a significant impact on how shareholders claim dilution claims in the future. Indeed, in many cases the Brookfield This decision will be decisive when a shareholder loses the right to assert a derivative claim after the merger because he no longer has a stake in the target company.

The content of this article is intended to provide a general guide on the subject. Specialist advice should be sought regarding your particular situation.

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