By Byron F. Egan and Kristina M. Campbell

Late in 2011, the Delaware Court of Chancery ruled on a summary judgment motion in Dubroff v. Wren Holdings, LLC, C.A. No. 3940-VCN (Del. Ch. Oct. 28, 2011) ("Dubroff II"), addressing claims—against both former directors and a former control group—brought by minority stockholders whose equity had been diluted as the result of a recapitalization.¹  In declining to dismiss direct claims of equity dilution by minority stockholders, and by allowing a fiduciary duty claim to proceed based on allegedly insufficient disclosures in certain stockholder communications, Vice Chancellor Noble's opinion highlights a variety of key issues, including:

1. a "control group" may be deemed a controlling stockholder for the purpose of supporting an equity dilution claim;
2. an equity dilution claim²  may be brought directly rather than derivatively; and
3. disclosure requirements for post-transaction notices delivered pursuant to §228(e) of the Delaware General Corporation Law.

This e-Alert takes a closer look at the Dubroff II decision, focusing on the issues above and the potential, as the case unfolds, for the expansion of liability for both directors and controlling stockholders in connection with recapitalization transactions.

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Facts

The Fuchs Plaintiffs acquired roughly 20% of Nine Systems Corporation's ("NSC") equity value from 1999 to 2002. Wren Holdings, LLC and two other entities (the "Control Group") collectively owned approximately 56% of NSC's equity value during this time. In early 2002, NSC's board of directors approved a resolution to borrow from Javva Partners and Wren Holdings. In addition, the Control Group approved a reorganization plan that involved a reverse stock split and issuance of new classes of shares. As a result, the Control Group held 90% of NSC's equity value. NSC stockholders executed a stockholders agreement as part of the recapitalization plan and then received an update notice a few months later that noted the stock split but did not disclose who benefited from it or what benefits they received. In 2006, NSC sent proxy materials to its stockholders, which for the first time allowed the Fuchs Plaintiffs to learn that they held only 6% of NSC's fully diluted securities. In 2010, the Fuchs Plaintiffs filed a complaint with the Delaware Court of Chancery.

Control Group Treatment

Under Delaware law, "control groups" within entities are accorded controlling stockholder status, and its members owe fiduciary duties to the minority stockholders of the corporation.³  A controlling stockholder is typically a single person or entity. However, the Delaware Chancery Court has recognized that a number of stockholders, each of whom cannot individually exert control over the corporation, can collectively form a control group when those stockholders work together toward a shared goal,⁴  and thus owe fiduciary duties to minority stockholders. The Dubroff II Court applied this control group theory, finding that Wren Holdings, LLC and two other stockholders acted as a single group to establish the exact terms and timing of the recapitalization, and thus constituted a control group with the resulting fiduciary obligations.

Equity Dilution

Under Delaware law, equity dilution claims are typically viewed as derivative, not direct.⁵  However, the Delaware Supreme Court established that certain equity dilution claims may be pled both derivatively and directly in Gentile v. Rossette.⁶  In Dubroff II, the Chancery Court followed Gentile in holding that the Fuchs Plaintiffs could plead direct equity dilution claims because they alleged facts showing that: (1) NSC's Control Group was able to control NSC and thus were controlling stockholders; (2) NSC's Control Group and the named director defendants were jointly responsible for causing NSC to issue excessive shares to NSC's Control Group; and (3) the effect of the recapitalization was "an extraction from NSC's public stockholders, and a redistribution to NSC's Control Group, of a substantial portion of the economic portion of the economic value and voting power embodied in the minority interest."⁷  The Chancery Court was also critical of other Delaware decisions that suggested that if anyone other than the controller benefits from the transaction, then the minority may not assert a direct dilution claim. The Dubroff II Court held that as long as the controller's holdings are not decreased, and the holdings of the minority stockholders are, the latter may have a direct equity dilution claim, even if someone other than the controller also benefits from the transaction.

Disclosure Requirements

DGCL Section 228(e) requires that after a majority approves a transaction by written consent: "prompt notice of the taking of the corporate action without a meeting by less than unanimous consent shall be given to those stockholders . . . who have not consented in writing."⁸  However, the contours of the disclosure required have not yet been fully defined under Delaware law. Although the Chancery Court did not clarify the requirements of Section 228(e) in Dubroff II, it did note that whatever the parameters of Section 228(e) may be, the Fuchs Plaintiffs pled sufficient facts for the Court to infer that the Board deliberately omitted material information with the goal of misleading stockholders. The Court noted that while the stockholders agreement and update notice accurately stated the mechanics of the recapitalization plan, including the stock split and exchange of preferred stock for certain indebtedness, this disclosure alone was not enough. Because the beneficiaries of and benefits from the recapitalization were not disclosed to stockholders, the Control Group did not satisfy the requirements of Section 228(e).

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Dubroff II serves as a very recent reminder from the Delaware Chancery Court that both directors and controlling stockholders must be careful when approving recapitalization plans that dilute the interests of minority stockholders. In addition to crafting recapitalization plans that do not impermissibly shift value from one group of stockholders to another, directors and controlling stockholders must also ensure that the disclosure provided in connection with such transactions is both timely and complete.

Jackson Walker's corporate attorneys have extensive experience in all areas of corporate governance, and are committed to helping corporations develop sound practices that best enable directors and control groups to fulfill their fiduciary duties during corporate transactions. For more information about developments in this area and how they affect your business, please contact any one of the following Jackson Walker corporate attorneys: