May 4, 2022
Del. Chancery Finds “Compelling Justification” for Dilutive Share Issuance
Last summer, the Delaware Supreme Court overruled a Chancery Court decision upholding a disputed share issuance used by an incumbent board to resolve a stockholder deadlock. The case arose out of failed negotiations to repurchase the plaintiff’s 50% ownership stake in the company. In response to the breakdown of those negotiations, she filed a lawsuit seeking to have a custodian appointed for the company in order to resolve the deadlock. The board responded by authorizing the issuance of shares to a key employee of the company in order to moot that custodianship proceeding, which led to this lawsuit.
The Chancery Court held that the transaction satisfied the entire fairness standard, but the Supreme Court said that because the case raised concerns about stockholder disenfranchisement, that was only the first step in the analysis. The Supreme Court pointed the Chancery in the direction of two prior decisions. The first, Schnell v. Chris-Craft Industries, held that actions taken by an interested board with the intent of interfering with a stockholder’s voting rights are a breach of the directors’ fiduciary duty. The second, Blasius v. Atlas Industries, held that even good faith actions by the board that have the effect of interfering with voting rights require a “compelling justification.”
On remand, Chancellor McCormick held in Coster v. UIP Companies, (Del. Ch.; 5/22), that the board did not act with an inequitable intent and that it had a compelling justification for its decision to issue the shares. At only 31 pages, Chancellor McCormick’s opinion is brief by Chancery standards, but it nevertheless devotes a lot of attention to the interpretive challenges presented by Schnell and Blasius. After wrestling with those challenges, the Chancellor ultimately concluded that at least in the context of stockholder-franchise challenges, Schnell applies “in the limited scenario wherein the directors have no good faith basis for approving the disenfranchising action.”
In the present case, she concluded that while the board may have been partially motivated by a desire to interfere with the plaintiff’s voting rights, but they were also motivated by a desire to act in the best interests of the company and prevent the harm to its business that would result from the appointment of a custodian. Accordingly, the board’s actions were not completely devoid of a good faith basis, and therefore should be evaluated under Blasius. The Chancellor then concluded that the board’s actions passed muster under the “compelling justification” test:
In the exceptionally unique circumstances of this case, Defendants have met the onerous burden of demonstrating a compelling justification. Defendants proved that the broad relief sought by Plaintiff in the Custodian Action rose to the level of an existential crisis for UIP. Defendants demonstrated that the appointment of a custodian could trigger broad termination provisions in key contracts and threaten a substantial portion of UIP’s revenue. Defendants also proved, more generally, that UIP was a services business dependent on personal relationships; thus, displacing oversight and managerial powers would defeat the founders’ purpose in forming UIP.
Chancellor McCormick also held that the share issuance was appropriately tailored to achieve the goal of mooting the custodian action while also achieving other important goals, including the implementation of a corporate succession plan and rewarding a key employee. She acknowledged that the share issuance eliminated the plaintiff’s ability to use her 50% interest to block stockholder action, but observed that it had the same effect on the other 50% owner by making the new employee-shareholder the swing vote.
– John Jenkins