DealLawyers.com Blog

Yesterday, in In re R1 RCM Inc. Merger Litigation (Del. Ch.; 10/26), the Chancery Court refused to dismiss allegations that a minority stockholder in a public company that possessed extensive contractual governance rights, including the ability to veto a variety of transactions and to nominate a majority of the company’s board, was a “Controlling Stockholder” within the meaning of Section 144 of the DGCL.

In assessing the plaintiffs’ allegations, Vice Chancellor Laster first noted that there are three potential triggers for controlling stockholder status set forth in Section 144’s definition of the term. The first trigger is ownership or control of a majority of the stockholder voting power (the “Stock-Majority Trigger”). The second trigger is the ability to cause the election of directors who can exercise a majority of the director voting power (the “Board-Majority Trigger”). The final trigger has three requirements: (1) ownership or control of at least one-third of the stockholder voting power, (2) power functionally equivalent to a majority stockholder, and (3) the ability to exercise managerial authority over the business and affairs of the corporation (the “Non-Majority Trigger”).

Because the stockholder beneficially owned less than a majority of the company’s voting power, the Stock Majority Trigger did not come into play. The Vice Chancellor rejected the plaintiffs’ allegation that the stockholder was a controller under the Non-Majority Trigger because it did not hold one-third of the company’s stockholder voting power unless warrants to purchase the company’s stock were included in the calculation, which the statute did not permit.

However, the Vice Chancellor refused to dismiss the plaintiffs’ allegations that the stockholder was a controller under the statute’s Board-Majority Trigger. In arguing that the Board-Majority Trigger was not satisfied, the defendants argued that statutory language requiring a stockholder to have “the right . . . to cause the election of [its] nominees” meant that a stockholder had to have the ability to make the election of its nominees a fait accompli, and that contractual conditions limiting the exercise of its right kept it from satisfying this requirement. The plaintiffs argued that this trigger could be satisfied by a stockholder having the functional ability to elect nominees.

Vice Chancellor Laster concluded that the plaintiffs had the better of the argument. The two conditions limiting the stockholder’s exercise of discretion with respect to its right to elect a majority of the board were one requiring the board to be comprised of a majority of independent directors if the company’s stock was listed on an exchange (the “Conditional Floor”) and one requiring that any nominee must be “reasonably acceptable” to the company (the “Acceptability Condition”).

As to the first condition, the Vice Chancellor observed that Nasdaq’s independence rules focus on company relationships and do not meaningfully limit the stockholder’s ability to nominate candidates. The defendants argued that Delaware law’s definition of a disinterested director as codified in the Section 144 safe harbor imposes further restrictions that needed to be taken into account.

The Vice Chancellor disagreed, noting that Delaware looks at the disinterestedness requirement on a transaction-specific basis and not through the abstract independence test required by the Conditional Floor. He went on to point out that treating potential transaction-specific conflicts as a total bar to independence would be unworkable, so Delaware law’s approach to disinterestedness should not apply. Accordingly, he did not view the Conditional Floor as imposing limitations on the stockholder’s discretion to nominate candidates sufficient to prevent the Board-Majority Condition to be satisfied.

The Vice Chancellor reached the same conclusion with respect to the Acceptability Condition, noting that the implied covenant of good faith and fair dealing, the common law imposes a reasonableness requirement on the exercise of a discretionary contractual right, and that the Acceptability Condition therefore simply restated what “background principles of law would require.”

The plaintiffs contended that once the Board Majority condition had been satisfied, the issue of controlling stockholder status also needed to be assessed under prior common law standards. Vice Chancellor Laster also rejected that argument, and concluded that satisfaction of the Board Majority Condition automatically resulted in classification of a stockholder as a “Controlling Stockholder” under the definition set forth in Section 144 of the DGCL.

– Meredith Ervine