Last week, VC Will dismissed the plaintiffs’ claims in The Gregory M. Raiff 2000 Trust v. Jenzabar, Inc., et al.. The complaint alleged a number of fiduciary breaches, including unearned stock giveaways to insiders over a period of 11 years that increased their ownership from 18% to 91%. Critically, the plaintiffs argued that the dilution of their voting power via the stock issuances was a direct claim, rather than a derivative one. VC Will disagreed:

These are quintessential derivative claims. In Brookfield Asset Management, Inc. v. Rosson, the Delaware Supreme Court confirmed that “equity overpayment/dilution claims, absent more, are exclusively derivative.” The harm alleged here—the improper extraction of corporate assets and equity—was suffered in the first instance by Jenzabar.  Any resulting dilution of the minority
stockholders’ voting power or economic interest is a secondary harm shared proportionally among all stockholders.  The recovery for such claims flows to the corporation.

The plaintiffs attempt to evade Brookfield by shoehorning their allegations into two recognized exceptions. Both arguments are unavailing.

First, the plaintiffs argue that the dilution claims are direct because the cumulative transactions “resulted in a . . . change in control” under Revlon, Inc. v. MacAndrews & Forbes Holdings, Inc. Brookfield acknowledged that a dilution based claim might be direct if it involves a transaction that shifts control from a diversified group of stockholders to a controlling interest, depriving the minority of a control premium.  But a creeping accumulation of stock over a decade is not a Revlon transaction.  There was no active bidding process, merger, or sale where Jenzabar’s stockholders were wrongfully deprived of a control premium.

There are two separate ideas here that are worth teasing out. The first is VC Will’s implicit suggestion that direct claims for dilution of control can only be brought in the context of some kind of active bidding process, merger, or sale. On that point, I actually interpret Brookfield differently; in my paper, The Three Faces of Control, I argued that Brookfield implied that specific reallocation of control rights away from some stockholders to others could give rise to a direct claim, focusing on this particular Brookfield quote:

To the extent the corporation’s issuance of equity does not result in a shift in control from a diversified group of public equity holders to a controlling interest (a circumstance where our law, e.g., Revlon, already provides for a direct claim), holding Plaintiffs’ claims to be exclusively derivative . . . is logical and re-establishes a consistent rule that equity overpayment/dilution claims, absent more, are exclusively derivative.

And, as I discussed in the paper, prior to Brookfield, there were a limited number of Chancery decisions that also held that when a board permits an insider to gain enough shares to achieve hard control, resulting fiduciary claims may be brought directly. For example, in Louisiana Municipal
Police Employees’ Retirement System v. Fertitta, 2009 WL 2263406 (Del. Ch. July 28, 2009), plaintiffs were able to bring direct claims that a board improperly failed to deploy a poison pill, which allowed the company’s chair and 46% stockholder to increase his stockholdings above 50% via open market purchases.

Notably, as I previously blogged, a couple of years ago, Chancellor McCormick seemed to agree with my interpretation of Brookfield in Cascia v. Farmer. There, Hertz engaged in a share buyback that increased a blockholder’s stake from 39% to 56%. Chancellor McCormick held that fiduciary claims could be brought both directly and derivatively.

But there was a second aspect to VC Will’s ruling, and that’s the idea that there’s a difference between handing control to someone in a relatively small and temporally-confined series of transactions, and distributing it slowly over a period of many years. That‘s actually a bit more complex to tease out, and at bare minimum, it might suggest that the direct claims in Jenzabar ripened at the moment the insiders’ holdings crossed the 50% threshold.

Anyhoo, this is an important issue that I hope the Delaware Supreme Court will provide some guidance on; as I pointed out in my previous blog post, there is a real chance at some point a board is going to sign a stockholder agreement with someone that gets challenged in a direct action, and Delaware will have to lay down ground rules about whether/when that is permissible.

And another thing. New Shareholder Primacy podcast is up!  Me and Mike Levin talk about VC David’s decision dismissing what were the last of the real Delaware claims against Tesla, and what it really would mean if a corporate board were to think like an activist.  Here at Apple; here at Spotify; and here at YouTube.