Saturday, May 9, 2020
I’ve blogged a lot about the complexities of Delaware’s controlling-stockholder jurisprudence (here, here, here, here, here, and here), and written an essay on the subject. The latest Chancery opinion on this issue, Gilbert v. Perlman, represents another, unusual, addition to the genre.
In Gilbert, Francisco Partners was the controlling stockholder of Connecture with a 56% stake. During its tenure, however, it worked closely with Chrysalis Ventures, a firm that it had coordinated with in prior ventures, and who was the next largest Connecture blockholder with an 11% interest. A Chrysalis partner, Jones, also served as Connecture’s Chair. Eventually, Francisco proposed to buy out the minority Connecture shareholders in a deal that was neither conditioned on the approval of an independent director committee nor a majority of the minority shareholder vote.
According to the proxy statement, the Connecture board, in the course of its internal deliberations, considered it important that Chrysalis support any proposed transaction. Chrysalis suggested that it be permitted to roll over its shares in the new entity, which would, it believed, allow Francisco to bump up the price for the remaining minority shareholders. A few days later, Jones asked for the same participation rights personally. A deal on these terms was struck. The unaffiliated shareholders, however, were unimpressed by the arrangement, voting only 9.9% in favor of the deal. But their votes were unnecessary and the merger closed.
Two minority shareholders of Connecture filed suit alleging that Francisco, as controller, breached its fiduciary obligations. Because Francisco had negotiated the deal with essentially no procedural protections for the minority, it was plain this was a transaction that would receive entire fairness review, and Francisco did not even bother moving to dismiss; instead, it simply answered the complaint. The more complex allegations concerned Chrysalis and Jones: plaintiffs alleged that they had formed a control group with Francisco and thereby shared its fiduciary obligations, and it was that question that Vice Chancellor Glasscock addressed on Chrysalis’s and Jones’s 12(b)(6) motion.
First, Glasscock articulated the basic landscape. As he put it:
Under Delaware law, “controlling stockholders are fiduciaries of their corporations’ minority stockholders.” That is, where a stockholder may control the corporate machinery to benefit itself, as by exercising voting control, it is a potential fiduciary. Where in fact it exerts such control, a controlling stockholder is bound by Delaware’s common law fiduciary duties of loyalty and care. Conversely, stockholders who control only their own shares, and cannot exert corporate control, are owed fiduciary duties; they themselves are not obligated to act in the corporate interest….
It is also possible under Delaware law for several minority stockholders to band together to form a “control group.” In this situation, though none are individually controllers, because they act in consort to exercise collective control, the stockholders in the group owe fiduciary duties. To demonstrate the existence of a control group, it is insufficient to identify a group of stockholders that merely shares parallel interests. To form a control group, the stockholders must be “connected in some legally significant way—e.g., by contract, common ownership, agreement, or other arrangement—to work together toward a shared goal.” By pooling resources in a plan by which they control the corporation, they become fiduciaries.
So, what if we have a controller who joins with minority shareholders? Do those minority shareholders inherit the same fiduciary obligations of a controller merely by virtue of their agreement, or is more required? Per Glasscock, we need more:
To create a control group, a controller must go beyond merely permitting participation by other stockholders in the transaction. Instead, the minority-holder’s participation must be material to the controller’s scheme to exercise control of the entity, leading to the controller ceding some of its control power to the minority-holders. In this way, the minority stockholders involved wield their own levers of power as part of the group; this control of the corporate machinery makes them fiduciaries. … [O]nly if the controlling stockholder shares or materially limits its own control power through an arrangement (such as a voting agreement) could a control group potentially be found….
In my view, where a controlling stockholder takes an action joined by minority stockholders, the latter can be deemed members of a control group, and thus fiduciaries, where two conditions exist. There must be an arrangement between the controller and the minority stockholders to act in consort to accomplish the corporate action, and the controller must perceive a need to include the minority holders to accomplish the goal, so that it has ceded some material attribute of its control to achieve their assistance. In order to survive a motion to dismiss, a plaintiff advancing this unusual theory must plead facts that permit a reasonable inference that these conditions exist.
Alas for the plaintiffs, they were unable to make such a showing. They definitely demonstrated the existence of an arrangement to act in concert – indeed, the parties disclosed in the proxy statement that they had entered into a voting agreement – and Chrysalis and Jones even received a nonratable benefit, namely, the right to rollover their stock. But the plaintiffs did not show that Francisco needed them in any way, or ceded its power, such that they shared fiduciary obligations with Francisco. As Glasscock put it:
if the Plaintiffs could have pled that Francisco Partners needed something material in way of its take-private scheme, and was accordingly willing to give up some material part of its control attributes to Chrysalis and Jones to get it, they may have adequately made the allegation that a control group existed here. The Complaint, however, points to neither quid nor quo—it describes nothing Francisco Partners needed or ceded to the Moving Defendants, other than the bare right to roll over shares.
The logic has a certain surface-level appeal. With great power comes great responsibility, and absent power, the responsibility does not follow. Therefore, gratuitous receipt of a controller’s largesse is not sufficient for the beneficiary to take on the controller’s responsibilities.
But beneath that simple maxim lies a raft of complexity.
First, as a practical matter, we may have trouble identifying which test applies. Recall, the rule is, in order to show that shareholders were working together – such that minority blockholders become controllers in the first instance – plaintiffs only need show the existence of an agreement. The enhanced test, requiring that the controller actually engage in a quid pro quo with someone else, only comes into play once the existence of a controlling shareholder is established. So imagine you have a large minority blockholder working with another, smaller blockholder. If the larger minority blockholder is incapable of exercising control on its own, the two together will owe fiduciary obligations if they reach an agreement; if, however, the larger blockholder does exercise control on its own, an agreement is not sufficient; the plaintiff will need to show that some of that power was ceded to the smaller in order to bring a claim against the two together. Given the inherent uncertainty associated with determining whether a minority blockholder exerts control in the first instance (see, ahem, my essay), you can already imagine the bizarre and conflicting set of incentives under which both plaintiffs and defendants will labor in order to make their cases at different stages of litigation.
Or, imagine you have three minority shareholders, any two of which are sufficient to control the entity. If the three shareholders combine, is only the third subject to the enhanced test? What if it’s not clear which are the “two” and which is the “third” – especially if the original two are alleged to have control from a minority (under 50%) position?
Maybe this is an angels-on-pinheads concern – after all, this scenario doesn’t come up much in general, and it probably doesn’t come up much with triad combinations – but we might further delve into what counts as a “benefit” to the controller that justifies a finding of a quid pro quo.
Here, there was not simply an agreement to act in concert: the minority shareholders received a unique benefit in the transaction, namely, Chrysalis and Jones were given the opportunity to roll over their shares, which was significant for a merger that, by hypothesis, undervalued the minority stake. (The fact that Jones immediately jumped on the deal personally is further evidence that this opportunity had real value, to the detriment of the minority shareholders being squeezed out).
But that was not enough for Glasscock: He required that Francisco have received something of value in exchange. What possibilities exist?
Here are some ideas. Apparently, because it was buying fewer minority shares, Francisco was willing to pay more for them (though the financial logic of that is not clear) – which would place it in a stronger legal position both in the (inevitable) fiduciary lawsuit or in an appraisal action. Plus, by maintaining good relations with Chrysalis, it avoided a lawsuit by Chrysalis itself - a significant threat, given that Jones was Chair of the Board and presumably knew where all the Francisco bodies were buried.
Also, Connecture was an unusual controlled company in that, as far as I can tell, Francisco had only put 2 nominees on a 7 member board (though plaintiffs alleged it had close ties to the remaining members). Chrysalis, of course, had the Chair. If Francisco wanted to force a merger through over board/Chrysalis objections, it would have had to go through the process of replacing the existing board members, including Jones. Could it have done so? Surely, but it would have taken time and placed it in an even more precarious legal position later. This is especially so given that, under federal law, Connecture was required to discuss the fairness of the proposed transaction in its proxy statement. Imagine the difficulty of doing so if the Chair of the board did not agree, or had been forced out in some kind of prolonged dispute.
The point is, even a cursory review of the facts reveals how Francisco benefitted by keeping matters amicable with Chrysalis. All of these possibilities suggest Chrysalis therefore had some control over the deal’s final shape; after all, the proxy statement itself stated that Chrysalis proposed higher minority shareholder consideration in exchange for its own participation.
So why aren’t these facts enough to meet Glasscock’s test?
One possibility is that this is simply a pleading matter. If plaintiffs had framed the case with these benefits made explicit, perhaps they’d have survived a motion to dismiss, with further factual development to come after discovery.
But if that’s the case, we might ask why this kind of pleading and proof are even necessary. If a controller grants a boon to a minority shareholder as part of a conflict transaction, why can’t we assume the controller is getting some kind of “soft” benefit in exchange? Why else would it ever agree to such an arrangement? Why can’t we view the specter of this kind of quid pro quo as sufficiently omnipresent to forego the necessity of proof? After all, we do that with controlling shareholder transactions generally; we assume that they are coercive to the minority even absent specific evidence that minority shareholders actually were coerced. We could similarly assume that if a controller confers a valuable benefit on a specific minority shareholder in connection with an self-interested deal, it’s not acting out of graciousness.
So the alternative possibility is that these soft benefits – which facilitated the transaction but were not, perhaps, legally necessary to complete it – were not, in Glasscock’s view, significant enough to rate. But if not, why not? Does Glasscock require actual proof of the control ceded by the controller (beyond, apparently, Chrysalis’s actual involvement in setting the price for the minority shares)? Or does Glasscock require different benefits to the controller? What would those benefits be?
I guess my thinking is, the whole reason we subject controlling shareholder transactions to heightened scrutiny is because we cannot trust the ordinary market mechanisms for disciplining predatory behavior. But that doesn’t mean controlling shareholders wield unconstrained power; as with anything else, their paths can be made rougher or smoother, and a smooth path may have value to the controller. As a result, even minority blockholders may wield influence. They can use that influence to ally themselves with the remaining minority, and thus make transactions more fair, or to ally themselves with controllers, in order to receive private benefits. To the extent Delaware law is designed to encourage “good” behavior that minimizes the need for judicial intervention, shouldn’t the rules in this area incentivize those blockholders to either maintain an alignment of interests with the minority shareholders, or bear legal responsibility for them?
Glasscock’s framing of the inquiry suggests some skepticism toward the notion that a controller would ever cede power to a minority blockholder, so that a plaintiff must allege an unusually explicit arrangement before the scenario will be contemplated. But, as I’ve repeatedly discussed in this space, control is not a simple on/off switch. Even a 56% stockholder may encounter obstacles in a take-private deal despite its legal ability to force it through. Delaware’s repeated insistence on viewing control through a black/white lens glosses over the practical realities of how control is often exercised, putting its doctrine at odds with the underlying reality.