October 7, 2019

Controllers: Del. Chancery Rejects Stock Offering Dilution Claims

Controlling shareholders can get a little grabby when it comes to stock issuances – and Delaware courts recognize that, in some circumstances, issuances that increase their ownership stake and dilute minority shareholders may breach the controller’s fiduciary duties.  But Vice Chancellor McCormick’s recent order in Daugherty v. Dondero, (Del. Ch.; 10/19), is a reminder that this isn’t always the case.

The plaintiff challenged two stock offerings by NextBank Capital that were completed in 2016 & 2017. The plaintiff alleged that the company’s board and its affiliates constituted a control group, and that they breached their fiduciary duties by using the offerings to dilute the plaintiff’s ownership interest. The plaintiff alleged that the offerings were made at a discount, and that while the offerings were open to all shareholders, only the company’s directors and officers (including members of the control group) were offered the opportunity to obtain loans from the company to facilitate their participation.

The plaintiff relied on the Delaware Supreme Court’s decision in Gentile v. Rossette, (Del.; 2006), in which the Court held that minority shareholders potentially had both direct & derivative claims in connection with transactions where “a controlling stockholder, with sufficient power to manipulate the corporate processes, engineers a dilutive transaction whereby that stockholder receives an exclusive benefit of increased equity ownership and voting power for inadequate consideration.”

The Vice Chancellor rejected the plaintiff’s contention that Gentile should apply to either offering.  As to the 2016 transaction, she noted that the control group itself was diluted, so Gentile simply didn’t apply.  While the 2017 transaction was dilutive to minority shareholders, she also concluded that it was inappropriate to apply Gentile to that transaction:

The Complaint also fails to state a claim under Gentile as to the 2017 Stock Offering, even though it resulted in a marginal increase to the Controlling Stockholders net equity and voting positions. This is so because Gentile and its progeny require that the expropriated benefit inure exclusively to the controllers.

Cases interpreting this exclusivity requirement have found it lacking where all stockholders are equally eligible to participate in the challenged transaction. Daugherty concedes that he and all other minority stockholders had the opportunity to participate in the Stock Offerings. Accordingly, Gentile does not apply.

VC McCormick also held that the insider loan program didn’t alter this analysis. While the plaintiff contended that the loan program was part and parcel of a scheme to benefit the control group, the Vice Chancellor observed that it extended to all of NextBank’s directors and officers, not just the members of the control group. Since that was the case, it didn’t extend an “exclusive benefit” to the control group.

John Jenkins