September 27, 2021

Controllers: Del. Supreme Court Holds Dilution Claims Are Derivative

Last year, I blogged about Vice Chancellor Glasscock’s decision in In re TerraForm Power, Inc. Stockholder Litigation, (Del. Ch.; 10/20), in which he held that dilution claims associated with an allegedly underpriced issuance of shares to a controlling stockholder were direct, not derivative, and therefore survived a motion to dismiss premised on the minority stockholders’ loss of standing due to a merger. Last week, the Delaware Supreme Court reversed his decision, and overturned the precedent upon which it was based in the process.

Vice Chancellor Glasscock’s opinion noted that while such claims would ordinarily be viewed as derivative under Tooley v. Donaldson, Lufkin & Jenrette, (Del.; 4/04), he was compelled to hold that the claim was direct by virtue of the Delaware Supreme Court’s decision in Gentile v. Rossette, (Del.; 8/06).  In Gentile, the Court held that fiduciary duty claims for an allegedly underpriced issuance of stock to a controller could be maintained by former stockholders as direct claims even though they no longer had standing to assert derivative claims.

The Vice Chancellor observed that the Gentile decision had been widely criticized, but felt that he was bound by existing precedent. However, he certified an interlocutory appeal to the Delaware Supreme Court, and in Brookfield Asset v. Rosson, (Del.; 9/21), the Supreme Court reversed his ruling & overruled Gentile.  In her 50-page opinion for the Court, Justice Valihura reviewed the doctrinal issues with the Gentile decision, and then pointed out that the exception to Tooley that it created was superfluous:

Aside from the doctrinal difficulties discussed above, we see no practical need for the “Gentile carve-out.” Other legal theories, e.g., Revlon, provide a basis for a direct claim for stockholders to address fiduciary duty violations in a change of control context. And as we observed in El Paso, “equity holders confronted by a merger in which derivative claims will pass to the buyer have the right to challenge the merger itself as a breach of the duties they are owed.” Such stockholders might claim that the seller’s board failed to obtain sufficient value for the derivative claims.

Justice Valihura’s opinion also noted that Gentile created the potential practical problem of allowing two separate claimants to pursue the same recovery, which could create double recovery issues. The plaintiffs argued that the Court should of Chancery devise a mechanism to “proportion” any recovery between the plaintiffs if both derivative and direct shareholders claim it, but the Court concluded that permitting such dual claims would unnecessarily complicate their resolution.

John Jenkins