November 30, 2020

Controllers: Del. Chancery Upholds Stock Issuance Dilution Claims (For Now)

In In re TerraForm Power, Inc. Stockholder Litigation, (Del. Ch.; 10/20), the Chancery Court refused to dismiss claims alleging that a company’s board & controlling shareholder breached their fiduciary duties by engaging in a private placement of stock to the controller at an inadequate price.

The plaintiffs’ allegations arose out of the company’s issuance of stock to the controlling stockholder in a private placement. The offering was conducted in order to finance an acquisition proposed by the controller, and was allegedly underpriced. The controller’s ownership interest in the company increased from 51% to just over 65% as a result of the transaction. The plaintiffs were minority shareholders and  originally asserted both direct & derivative claims, but the derivative claims were dismissed after the controlling shareholder acquired the company’s remaining shares in a merger. 

Vice Chancellor Glasscock’s decision in this case addressed the direct claims. This excerpt from a recent Shearman blog on the case discusses his reasoning:

The Delaware Supreme Court’s decision in Tooley v. Donaldson, Lufkin & Jenrette, Inc., 845 A.2d 1031 (Del. 2004), generally sets the framework for distinguishing between “derivative” and “direct” claims. That decision held that the determination “must turn solely on the following questions: (1) who suffered the alleged harm (the corporation or the suing stockholders, individually); and (2) who would receive the benefit of any recovery or other remedy (the corporation or the stockholders, individually)?” In order to plead a “direct” claim under Tooley, a “stockholder must demonstrate that the duty breached was owed to the stockholder and that he or she can prevail without showing an injury to the corporation.”

Thus, as Vice Chancellor Glasscock explained, claims that the corporation improperly transferred value to a third party are “not regarded as direct” because the dilution of value of the corporation’s stock “merely” reflects the “reduction in the value” of the entire corporation itself.

According to the Vice Chancellor, “[t]his rationale extends even where a controlling stockholder allegedly causes a corporate overpayment [to itself] in stock and consequent dilution of the minority interest.” This is because “the worth of the stockholder’s interest is reduced to the extent the entity was harmed.” In other words, “[t]he harm is suffered by the entity, and restoring value to the entity would make both it and, derivatively, its stockholders, whole.” Therefore, under the “classic” Tooley framework, the claims alleged by plaintiffs in this case would be “derivative”—rather than “direct”—and thus subject to dismissal for lack of standing.

Nevertheless, the Vice Chancellor denied the motion to dismiss because the Delaware Supreme Court upheld nearly identical claims in Gentile, which was decided two years after Tooley. Specifically, in Gentile, the Delaware Supreme Court found that breach of fiduciary duty claims for the alleged issuance of stock to a controlling stockholder for inadequate value could be maintained by former stockholders as “direct” claims even though they no longer had standing to assert “derivative” claims.

The Vice Chancellor Glasscock noted that Gentile v. Rossette has been subject to a great deal of criticism, but said that as a trial court judge, he was bound by the Delaware Supreme Court’s precedent & that, as such, Gentile required him to conclude that the direct claims in this case must survive the motion to dismiss.

But that may not be the end of the standing issue in this case. That’s because the Vice Chancellor followed up his opinion with a letter opinion granting a motion for an interlocutory appeal to the Delaware Supreme Court. As this excerpt notes, the issue to be addressed in the appeal is whether Gentile continues to be good law:

Again, in light of case law questioning the continued vitality of Gentile at the trial court level, and in light of criticism at the Supreme Court level, I find it in the interest of justice that the matter be available for review by the Supreme Court at this Motion to Dismiss stage.

John Jenkins