Entire Fairness or Business Judgment? It’s Anyone’s Guess
In lawsuits challenging the validity of business transactions and combinations, the most significant issue is often which standard of review the court applies: the defense-friendly “Business Judgment Rule” or the more stringent “Entire Fairness Standard.” The standard utilized by the court – or more often times the standard which the parties think the court will apply – can drive decisions on motion practice, settlement discussions, and resolution strategy. Under the Business Judgment Rule, directors are presumed to have acted in good faith and their decisions will only be questioned when they are shown to have engaged in self-dealing or fraud. However, if a “Controlling Shareholder” stands on both sides of the transaction, the court will often scrutinize the transaction under the more plaintiff-friendly “Entire Fairness Standard.”
So, what constitutes a “Controlling Shareholder?” If the party in question owns more than 50% of a company’s equity, the answer is clear-cut. However, for cases involving stockholders who own less than 50% of a company’s equity and stand on both sides of the disputed transaction, the answer is not so simple. This uncertainty was highlighted in back-to-back decisions by the Delaware Chancery Court in November 2014. On November 25, 2014, the court granted the defendants’ motion to dismiss a derivative lawsuit alleging breach of fiduciary duty in In Re Sanchez Energy Derivative Litigation (“Sanchez”). Vice Chancellor Glasscock held that the complaint failed to plead facts sufficient to raise an inference that two directors with a collective 21.5% equity interest in the company were Controlling Shareholders. The very next day, in In Re Zhongpin Inc. Stockholders Litigation (“Zhongpin”), the Delaware Chancery Court denied the defendants’ motion to dismiss breach of fiduciary duty claims against an alleged “Controlling Shareholder” and members of the company’s board. In Zhongpin,Vice Chancellor Noble held that sufficient facts were plead to raise an inference that a CEO with a 17.5% equity was a “Controlling Shareholder.”
Sanchez and Zhongpin - “Actual Control of Corporate Conduct”
To establish that a defendant is a “Controlling Shareholder” “[w]hen [that] stockholder owns less than 50% of the corporation’s outstanding stock, a plaintiff must allege domination by a minority shareholder through actual control of corporate conduct.” In re Morton’s Rest. Grp. Inc. S’holders Litig., 74 A.3d 656, 664 (Del. Ch. 2013) [emphasis added]. In Sanchez, the Court defined “actual control of corporate conduct” as “actual control over the corporation’s board of directors.” Sanchez at 20. The plaintiffs in Sanchez argued that directors Sanchez Jr. and Sanchez III (who held a combined 21.5% equity stake), were “Controlling Shareholders” because the company was a shell company established by the Sanchez family to take advantage of public funding, and because the company had no employees and no directly managed operations. The plaintiffs also alleged that Sanchez Jr. and Sanchez III maintained firm control over operations and the boards as Sanchez III served as both President and CEO. However, Vice Chancellor Glasscock held that the allegations did not support a reasonable inference that Sanchez Jr. and Sanchez III: (1) exercised greater control than that of a typical CEO; (2) dominated or controlled the board; or (3) even attempted to dominate the board through threats, bullying, or the like. Indeed, in determining that the allegations were insufficient to raise an inference that the defendants were “Controlling Shareholders,” Vice Chancellor Glasscock noted the plaintiffs’ admission at oral argument that the defendants could not even exert the power necessary to remove a dissenting director.
In Zhongpin, the Court defined “actual control of corporate conduct” as when the stockholder’s “voting power and managerial authority, when combined, enable him to control the corporation.”; Zhongpin at 16. To establish a “Controlling Shareholder” inference, the plaintiffs in Zhongpin relied on statements made in the company’s Form 10-K which disclosed that the CEO “ha[d] significant influence over [the] management and affairs and could exercise this influence against [shareholders’] best interests.” Zhongpin at 17. The Form 10-K further disclosed that the CEO could exercise significant influence over the company through “any shareholder approvals for the election of our directors and, indirectly, the selection of our senior management, the amount of dividend payments, if any, our annual budget, increases or decreases in our share capital, new securities issuance, mergers and acquisitions and any amendments to our By-laws.” Id. In holding that the complaint plead facts sufficient for the court to infer that the CEO was a “Controlling Shareholder,” Vice Chancellor Noble further noted that the company did not receive any additional bids for the merger during the “go-shop” period, and that this could mean that the CEO’s grip on the company discouraged all potential acquirers from obtaining control of the company.
A Look Ahead – Control “Against Best Interests”
The determination of who is a “Controlling Shareholder” is significant because in most cases, a finding of “control” means the defendants will not be entitled to the protection of the Business Judgment Rule, and will instead be subject to the more rigorous “Entire Fairness Standard.” Both Sanchez and Zhongpin suggest that plaintiffs must plead specific facts which allow the court to make an inference that the shareholder has enough of a grip on the company and its management to exert control “against the best interests” of the other shareholders. The key question will likely continue to be whether the defendant exercised control greater than that of a typical CEO. We expect that the Delaware courts will continue to weigh in on this critical issue in the year ahead.
For more information regarding this alert, please contact Maurice Pesso (212.631.4405; email@example.com), Greg Steinberg (212.714.3066; firstname.lastname@example.org) or Christopher Orrico (212.631.4419; email@example.com).