July 12, 2006
VC Strine Addresses Duties of Selling Controlling Shareholder
In this short decision by Delaware Vice Chancellor Strine, the court dismissed claims against a controlling stockholder that had sold its control block for a premium.
The complaint alleged that (i) the controlling stockholder had received excess payments from the buyer, not for its majority interest, but as a payment for permitting the buyer to usurp the assets of the target to the detriment of the minority/remaining stockholders and (ii) the controlling stockholder had breached its duty of loyalty by permitting, aiding and abetting, the buyer’s unfettered use and enjoyment of the target’s assets without fair compensation.
While quickly dismissing the complaint for failing to state a cause of action on which relief could be granted, the decision is probably of greater interest for dicta (i) confirming the general right of a controlling stockholder to sell its majority bloc for a premium not shared with other target stockholders and (ii) suggesting additional limits on the potential liability of a controlling stockholder where the target’s certificate of incorporation contains an exculpatory provision authorized by Section 102(b)(7) of the DGCL.
Background (according to the complaint)
– Sport Supply was 53.2% owned by Emerson Radio
– Sport Supply voluntarily delisted its stock in early 2004 but continued to trade on the pink sheets.
– By late 2004, the share price had risen from the $1-$2 range to $3 per share
– By mid 2005, it was trading at $3.65 per share.
On July 5, 2005, Emerson Radio announced that it had sold its majority stake for $32 million or $6.74/share, an 86% premium to the prior day’s closing price, to Collegiate Pacific, a competitor formed by Sport Supply’s founder and former CEO.
On September 8, 2005 Collegiate announced that it had agreed to an uncollared stock-for-stock merger with Sport Supply pursuant to which the minority holders of Sport Supply would receive 0.56 of a share of Collegiate stock valued at announcement at $6.74.
Unfortunately, Collegiate’s share price began to drop as a result of increased acquisition costs and earnings dilution resulting from the conversion of outstanding notes into common equity and the merger agreement was ultimately terminated. In the interim, a large institutional shareholder sold a significant block of Sport Supply stock to Collegiate for $5.50 per share in cash.
By the time the complaint was filed, Sport Supply shares were trading at $4.85 per share.
After reviewing the complaint, the court concluded that while there is precedent suggesting that a controlling stockholder who sells to a looter may be held liable for breach of fiduciary duty, the complaint failed to plead circumstances suggesting that the controlling stockholder knew, suspected or should have suspected that the buyer was either a looter or was dishonest and had improper plans.
“Even assuming for the sake of argument that a controlling stockholder can be held liable for negligently selling control to a buyer with improper motives (as opposed to when it know it is selling to a looter or an otherwise dishonest and predatory buyer), . . . [t]he complaint is devoid of facts supporting a rational inference that the controller should have suspected that the buyer, another listed public company, had plans to extract illegal rents from the subsidiary. At most, the complaint pleads facts suggesting that the controller knew that it was selling to a strategic buyer who would attempt to capitalize on possible synergies between itself and its new non-wholly owned subsidiary. That mundane prospect provides no rational basis for a seller to conclude that the buyer intends to embark on a course of illegal usurpation of the subsidiary’s assets for its own unfair benefit.”
Conceding that the precedent suggests that “a duty devolves upon the seller to make such inquiry as a reasonably prudent person would make, and generally exercise care so that others who will be affected by his actions should not be injured by [the] wrongful conduct,” Vice Chancellor Strine stated that he was “dubious that our common law of corporations should recognize a duty of care-based claim against a controlling stockholder for failing to (in a court’s judgment) examine the bona fides of a buyer, at least when the corporate charter contains an exculpatory provision authorized by 8 Del. C. Section 102(b)(7).
After all, the premise for contending that the controlling stockholder owes fiduciary duties in its capacity as a stockholder is that the controller exerts its will over the enterprise in the manner of the board itself. When the board itself is exempt from liability for violations of the duty of care, by what logic does the judiciary extend liability to a controller exercising its ordinarily unfettered right to sell its shares? I need not answer that question here, but do note that the unthinking acceptance that a greater class of claims ought to be open against persons who are ordinarily not subject to claims for breach of fiduciary duty at all – stockholders – than against corporate directors is inadequate to justify recognizing care-based claims against sellers of control positions.”
Vice Chancellor Strine goes on to carefully note that “drawing the line at care would do nothing to immunize a selling stockholder who sells to a known looter or predator, or otherwise proceeds with a sale conscious that the buyer’s plans for the corporation are improper. But it would impose upon the suing stockholders the duty to show that the controller acted with scienter and did not simply fail in the due diligence process.”