Delaware Court Of Chancery Holds That Former Stockholders Can Pursue Direct Claims For Breach Of Fiduciary Duty Arising From Issuance Of Shares To Controlling Stockholder For Allegedly Insufficient Consideration
On October 30, 2020, Vice Chancellor Sam Glasscock III of the Delaware Court of Chancery upheld breach of fiduciary duty claims brought by former stockholders of TerraForm Power, Inc. (the “Company”) against its majority stockholder, CEO, and several directors. In re TerraForm Power, Inc. Stockholder Litigation, C.A. No. 2019-0757-SG (Del. Ch. Oct. 30, 2020). Plaintiffs alleged that the Company engaged in a private placement of stock to the controlling stockholder at a price that undervalued the shares that were issued. Accordingly, plaintiffs contended that the transaction diluted the financial and voting interest of the minority stockholders. Defendants moved to dismiss for lack of standing, arguing that such dilution claims are “quintessential derivative claims” that cannot be asserted by former stockholders. Vice Chancellor Glasscock, however, denied the motion to dismiss under “controlling precedent” because the Delaware Supreme Court upheld similar claims by former stockholders in Gentile v. Rossette, 906 A.2d 91 (Del. 2006).
In 2018, the Company allegedly engaged in a private placement of stock to the controlling stockholder to finance an acquisition proposed by the controlling stockholder. The private placement was allegedly underpriced and increased the controlling stockholder’s voting power from 51% to 65.3%. Indeed, after the contemplated acquisition, the Company’s stock traded at a price of more than 10% greater than the private placement price. Plaintiffs, who were minority stockholders, initially filed suit in September 2019 asserting claims for breach of fiduciary duty styled as both “direct” and “derivative.” In July 2020, the controlling stockholder acquired the remaining shares in a merger and the Court thereafter dismissed the “derivative” claims for lack of standing because plaintiffs were no longer stockholders. This new decision addressed the claims that had been asserted as “direct” claims.
Stockholder claims for breaches of fiduciary duty against corporate fiduciaries can be “derivative” or “direct.” Stockholder “derivative” claims belong to the corporation, but may be asserted by current stockholders (who were also stockholders at the time of the alleged wrongdoing) on behalf of the corporation (subject to various limitations). Claims that are “direct” belong to—and can be asserted directly by—the allegedly injured stockholders themselves. The Delaware Supreme Court’s decision in Tooley v. Donaldson, Lufkin & Jenrette, Inc., 845 A.2d 1031 (Del. 2004), generally sets the framework for distinguishing between “derivative” and “direct” claims. That decision held that the determination “must turn solely on the following questions: (1) who suffered the alleged harm (the corporation or the suing stockholders, individually); and (2) who would receive the benefit of any recovery or other remedy (the corporation or the stockholders, individually)?” In order to plead a “direct” claim under Tooley, a “stockholder must demonstrate that the duty breached was owed to the stockholder and that he or she can prevail without showing an injury to the corporation.”
Thus, as Vice Chancellor Glasscock explained, claims that the corporation improperly transferred value to a third party are “not regarded as direct” because the dilution of value of the corporation’s stock “merely” reflects the “reduction in the value” of the entire corporation itself.
According to the Vice Chancellor, “[t]his rationale extends even where a controlling stockholder allegedly causes a corporate overpayment [to itself] in stock and consequent dilution of the minority interest.” This is because “the worth of the stockholder’s interest is reduced to the extent the entity was harmed.” In other words, “[t]he harm is suffered by the entity, and restoring value to the entity would make both it and, derivatively, its stockholders, whole.” Therefore, under the “classic” Tooley framework, the claims alleged by plaintiffs in this case would be “derivative”—rather than “direct”—and thus subject to dismissal for lack of standing.
Nevertheless, the Vice Chancellor denied the motion to dismiss because the Delaware Supreme Court upheld nearly identical claims in Gentile, which was decided two years after Tooley. Specifically, in Gentile, the Delaware Supreme Court found that breach of fiduciary duty claims for the alleged issuance of stock to a controlling stockholder for inadequate value could be maintained by former stockholders as “direct” claims even though they no longer had standing to assert “derivative” claims.
Vice Chancellor Glasscock emphasized that efforts to reconcile Gentile with the broader framework for distinguishing between “derivative” and “direct” claims are “as a matter of doctrine, unsatisfying” and that the decision in Gentile has been repeatedly criticized. Indeed, as highlighted by the Vice Chancellor, the former Delaware Chief Justice Leo Strine noted in a 2016 concurrence that Gentile “is a confusing decision, which muddies the clarity of our law in an important context.” But the Vice Chancellor concluded that “[a]s a trial court judge, [he is] not free to decide cases in a way that deviates from binding [Delaware] Supreme Court precedent” and Gentile “mandates that the direct claims pled survive.”