Friday, January 13, 2023
This is sort of arcane, but I am fascinated by two decisions that came out of Delaware this week from VC Laster and VC Glasscock. They are remarkably similar in facts and result, but travel slightly different paths to get there.
The first case, Harris v. Harris, concerned a family corporation. The mother was alleged to have systematically looted the company and – aware that a books-and-records action was likely to be filed by her children – forced through a merger with a shell New Jersey entity. After the merger, all of the former shareholders of the old corporation now held identical interests in the new corporation, which was the same in every respect, except for the new state of organization.
The second case, In re Orbit/FR Stockholders Litigation, concerned a corporation with private equity investors. The controller, a French corporation, was alleged to have systematically looted the company, and then effectuated a cash squeeze out merger in order to avoid any potential claims for breach of fiduciary duty.
Because in both cases, the minority stockholders no longer held shares in the looted entity – they held shares in the reorganized entity in Harris, and cash in Orbit/FR – the controller argued they had lost standing to pursue fiduciary claims based on pre-merger conduct.
Now, as background, in In re Primedia, Inc. Shareholders Litigation, 67 A.3d 455 (Del. Ch. 2013), VC Laster held that when derivative claims are extinguished in a merger, the shareholders of the old corporation may be able to bring direct claims arguing that the merger consideration was unfair due to failure to value the derivative claims and include them in the merger consideration. To succeed on a Primedia claim, the plaintiff must plead the existence of viable pre-merger derivative claims, that were material in the context of the merger, and that the buyer would not pursue the claims therefore no value was received for them. The Delaware Supreme Court adopted the Primedia framework in Morris v. Spectra Energy P’rs (DE) GP, LP, 246 A.3d 121 (Del. 2021).
In Orbit/FR, the controlling shareholder argued that the plaintiffs could not meet the pleading requirements of Primedia, in large part because any derivative claims that could have been brought against the controller were time-barred – shareholders should have brought the claims earlier and did not, therefore, they had no value, therefore, they did not need to be valued in the merger. The shareholder-plaintiffs argued that what shareholders did or didn’t do was beside the point; the claims belonged to the company, and a controlling shareholder can’t time-bar claims against itself by having the controlled board refuse to bring them.
All of that is in the briefing, but isn’t addressed by VC Glasscock, who side-stepped it by concluding that Primedia is the wrong framework. (He did address a laches argument but – this is confusing – it was a different laches argument, one concerning the fact that the plaintiffs had actually substituted in for earlier plaintiffs who filed a suit in 2018 and then attempted to settle for amounts that the new plaintiffs deemed inadequate).
In Glasscock’s view, Primedia is reserved for cases where a third party buys the company, has no interest in pursuing the old derivative claims, and therefore does not pay for them. He noted there are “stringent” requirements for pleading such a claim, “in light of the general rule that the derivative asset had transferred to the acquiror, and was not retained by the former stockholders.”
Orbit/FR, however, was more like a straightforward entire fairness case, in which a controller stood on both sides of the transaction. The shareholders had never filed a breach of fiduciary duty claim against the controller for its premerger conduct; instead, the only claim was that the controller looted the company and then effectuated an unfair merger, in part because it bought out its own liability for no value. Per Glasscock, “to the extent the existence of a pre-merger litigation asset, held by Orbit, contributes to a finding of the unfairness of the merger, that unfairness is not extinguished via the merger; it is created by the merger.” The plaintiff had adequately pled an unfair merger, and therefore it would be appropriate for the court to assess fairness in light of all of the assets of the acquired company, including its choses in action.
So. Primedia did not apply; plaintiffs’ claims survived the motion to dismiss.
Harris was bit more complex, in that the minority-shareholder-plaintiffs really did plead premerger fiduciary breaches against their mother, the controlling shareholder, in addition to other claims. In that context, VC Laster also invoked Primedia, but, in his view, though Primedia itself involved a third party buyer, its logic was descended from the squeeze-out case of Merritt v. Colonial Foods, Inc., 505 A.2d 757 (Del. Ch. 1986), where a controller effectuated a merger for the purpose of eliminating derivative claims, and the minority shareholders were permitted to use those claims to demonstrate the unfairness of the merger price. In Laster’s view, then, Primedia is simply a specific instance of a general rule that when a merger eliminates derivative claims, those claims are treated as assets of the target company and the fairness of the merger is assessed accordingly. And, further demonstrating that he believed Primedia simply to be an extension of earlier caselaw, Laster noted that the plaintiffs might not need to show that the value of the claims was material in light of the overall merger consideration – as Primedia suggests – if the unfairness of the merger can be pled by other means:
In Parnes, the Delaware Supreme Court did not hold that a stockholder only could assert a direct claim challenging a merger by pleading facts indicating that the value of the diverted proceeds were so large as to render the price unfair. The Delaware Supreme Court instead recognized more broadly that a stockholder could assert a direct claim challenging a merger if the facts giving rise to what otherwise would constitute a derivative claim led either to the price or to the process being unfair. In Primedia, the court identified this dimension of Parnes and explained that “[t]here is a strong argument that under Parnes, standing would exist if the complaint challenging the merger contained adequate allegations to support a pleadings-stage inference that the merger resulted from an unfair process due at least in part to improper treatment of the derivative claim.”
Using the Primedia framework, Laster, like Glasscock in Orbit/FR, went on to find that the minority stockholders in Harris could pursue their claims as a direct attack on the fairness of the merger.
So the cases reached the same result, but differed on the applicability of Primedia. Do these divergent approaches make much of a difference? Possibly. Glasscock seemed to think Primedia requires the pleading of very specific elements, so categorizing a claim as “Primedia” or “not Primedia” really matters for whether a complaint is sufficient; the Primedia pleading burden was avoided in Orbit/FR by viewing the case through the simple lens of whether the plaintiffs had alleged facts that made it reasonably conceivable that a controlling shareholder freezeout merger was unfair. Laster, by contrast, did not view Primedia so narrowly; though he found the formal elements met in Harris, he also went out of his way to note that Primedia’s test is really just a mechanism for assessing whether unfairness has been pled.
Conceptually, I do agree with Laster that there is really one unified concept here, namely, the extent to which a derivative claim is an asset of the target and whether its treatment renders the merger unfair to the selling stockholders. The facts necessary to plead such a claim should be a separate issue that is adjusted as the circumstances warrant.
Another interesting point of note, though: In Harris, Laster also held that the minority plaintiffs satisfied the two exceptions that exist to the continuous holding rule for derivative standing. As Laster pointed out, the continuous holding rule is waived if the merger is effectuated solely for the purpose of eliminating the derivative claims (known as the “fraud exception,” Ark. Tchr. Ret. Sys. v. Countrywide Fin. Corp., 75 A.3d 888 (Del. 2013)), and it is also waived if the merger is a mere reorganization of the old corporation with no substantive changes. Here, that’s exactly what happened on both counts, but Laster concluded that it would be administratively simpler to treat this as a direct claim, and that’s what he did.
Which means, among other things, we now have at least one example of a case where the fraud exception to the continuous holding rule was in fact met, which I think is – new? If there others, I don’t know what they are – feel free to let me know in the comments if it’s been done before.