Delaware Court Of Chancery Finds Company’s Founders Constitute Control Group And That Entire Fairness Applies To Transaction In Which They Obtained Benefits Not Available To Minority Stockholders
On June 1, 2021, Chancellor Kathaleen St. J. McCormick of the Delaware Court of Chancery denied defendants’ motion to dismiss a stockholder derivative action against the founders of Tilray, Inc. (the “Company”) for breach of fiduciary duties in connection with a merger with Privateer Holdings, Inc., a parent entity through which the Company’s founders had maintained their holdings. In re Tilray, Inc. Reorganization Litig., C.A. No. 2020-0137-KSJM (Del. Ch. June 1, 2021). The alleged purpose of the merger was to effect a reorganization of the business to mitigate expected federal capital gains tax consequences that the founders would incur in connection with the anticipated divestment of their holdings. The Court found that the Company’s three founders constituted a control group and that the reorganization constituted a self-dealing transaction subject to entire fairness review. The Court also found that demand on the board would have been futile as a majority of the board was conflicted.
The Company’s three founders collectively owned 73% of the parent, which in turn owned 75% of the Company’s equity and controlled over 90% of the Company’s voting power (as a result of differential voting rights among two classes of stock). Allegedly in connection with the founders’ desire to obtain liquidity, the parent proposed—and ultimately consummated—a tax-free reorganization, involving the merger of the parent into the Company and the issuance of stock in the Company to the founders. Plaintiffs alleged that the founders, as a control group, breached their fiduciary duties by using the reorganization “to unfairly extract unique, non-ratable tax benefits” from the Company and its minority stockholders. The founders contended that they did not constitute a control group and thus had no concomitant fiduciary obligations. Defendants also argued that the transaction did not involve self-dealing and was thus entitled to deference under the business judgment standard.
The Court held that plaintiffs adequately pleaded that the founders comprised a control group as the complaint alleged a “concurrence of interests” among the founders along with several “plus factors.” Specifically, the Court found that plaintiffs sufficiently alleged that the founders collectively shared a “desire to avoid massive tax liability associated with the substantial increase on [their] initial investment,” which was “not shared by other . . . stockholders.” The Court also found that plaintiffs adequately alleged “historically and currently significant ties and transaction-specific ties among the [f]ounders,” including that they (i) were “long-time friends”; (ii) founded the parent and jointly managed the Company and other portfolio companies; (iii) “held each other out as ‘partners’” and defined themselves in organizational documents as the “Founders”; and (iv) negotiated the reorganization collectively.
The Court also rejected defendants’ contention that entire fairness review did not apply because the tax benefits “were not extracted from and were never available to [the Company’s] minority stockholders” and the reorganization “caused no detriment to the minority.” The Court instead found that multiple decisions have held that “entire fairness presumptively applies whenever a controller extracts a non-ratable or unique benefit.” The Court added that—to the extent a detriment to the minority is required to be pleaded—the complaint here adequately demonstrated that it was “reasonably conceivable” that the Company’s board failed to exert its leverage over the founders to the detriment of the minority.
The Court also found that pre-suit demand on the board was excused as futile because a majority of Company’s five directors were interested. There was agreement among the parties that one of the directors was conflicted and two were not. As to the remaining two, the Court found that one was inherently conflicted in this transaction because he was a director of both the Company and the parent. As to the other, the Court found that the complaint sufficiently pleaded that she was “beholden” to the founders because she was a leader at a lobbyist group for which the parent and the Company were among the “most important clients.”