Delaware Court Of Chancery Validates Ratification Of Defective Corporate Acts Impacting Merger And Declines To Expand Universe Of Claims Classified As Both Direct And Derivative
On August 17, 2018, Chancellor Andre G. Bouchard of the Delaware Court of Chancery denied all of plaintiffs’ claims challenging a series of transactions culminating in the acquisition of defendant Design Within Reach, Inc. (“DWR”) by Herman Miller, Inc. (“HM”) in July 2014. Charles Almond as Trustee for the Almond Family 2001 Trust v. Glenhill Advisors LLC, C.A. No. 10477-CB (Del. Ch. Aug. 17, 2018). The claims related in large part to the documentation of a reverse stock split by DWR in 2010 that had the unintended effect of diluting the number of shares of common stock into which preferred stock could be converted by a factor of 50. As this went unnoticed until after the merger, the preferred stock was converted into common stock as if there had been no error. Plaintiffs, who were pre-merger minority stockholders of DWR, asserted various claims that defendants, including DWR’s controlling stockholder, thus improperly benefited from a greater percentage of equity and merger consideration than that to which they were legally entitled. HM ratified the correction of the conversion factor (pursuant to 8 Del. C. § 204) and asserted a counterclaim for judicial validation of the defective corporate acts (under 8 Del. C. § 205). Finding all relevant factors weighed “overwhelmingly in favor of judicial validation” the Court granted defendants’ request to validate the defective corporate acts and rejected plaintiffs’ claims. Separately, the Court rejected breach of fiduciary duty claims unrelated to the merger. It concluded that the challenged transactions did not result in the improper transfer of economic value and voting power from the minority stockholders to the controlling stockholder such that they could be maintained as direct claims rather than derivative claims (which plaintiffs, as former stockholders, lacked standing to assert).
In 2010, the DWR board sought to stem the volatility in prices of DWR common stock by instituting a 50-to-1 reverse stock split of DWR common stock. Unbeknownst to all parties involved at the time, an attempt to maintain the conversion ratio for preferred stock had the unintended effect of reducing by a factor of 2,500-to-1, rather than 50-to-1, the number of shares of common stock into which shares of preferred stock could convert. In advance of and in connection with the merger, the preferred stock was converted to common stock in the intended proportion because the erroneous documentation remained unnoticed. Following discovery of the error after the merger, HM sought to correct the issue through ratification of the intended—but defective—corporate act by, among other things, amending the preferred stock certificate of designation (“COD”) to permit the prior conversions at the intended rate. Plaintiffs sought to hold the defendants to the conversion ratio as erroneously documented.
The Court found that the COD was “part of the Company’s certificate of incorporation” and thus the conversion of the preferred stock in a ratio inconsistent with the COD would be a “void” corporate act, susceptible to judicial validation under Section 205 of the Delaware General Corporation Law, 8 Del. C. § 205. Evaluating the factors set forth in the statute, the Court concluded that validation was clearly warranted. Specifically, the Court noted that (i) the board effectuated the reverse stock split with the “reasonable belief” that it would be carried out by counsel as intended and in accordance with the law, (ii) the board always treated the transaction as if it had been completed as intended and numerous parties had relied on its validity, (iii) ratification would not result in any harm (other than precluding plaintiffs from obtaining a “windfall”), (iv) the preferred stockholders and others would be harmed if the unintended defect was left to stand, and (v) “ratification is clearly the equitable outcome.”
The Court next addressed plaintiffs’ breach of fiduciary duty claims relating to allegations that certain defendants unfairly benefited from various financing and restructuring transactions in the years before the merger. The Court noted that some of the transactions “involved self-dealing … in which all members of the Board were conflicted … and which otherwise would be subject to entire fairness review.” Nevertheless, the Court held that plaintiffs’ claims, which it classified as “overpayment claims,” did not fall within the “species of corporate overpayment claims” that could be characterized “as both direct and derivative in nature” so as to enable plaintiffs—who no longer had derivative standing—to maintain the suit after the merger.
First, the Court explained that the exception to derivative classification for such claims is only applicable where there is “an improper transfer of both economic value and voting power from the minority stockholders” to a controlling stockholder. Here, the Court found that the controlling stockholder—which held greater than 80% of the equity—was plainly diluted in connection with the challenged transactions. The Court also rejected a “novel” argument advanced by plaintiffs that certain other defendants should have been considered part of a “control group” with the controlling stockholder and, therefore, a transfer of economic value and voting power to those defendants was subject to a direct claim. The Court highlighted that “plaintiffs have identified no case—and the court is aware of none—where the analysis for determining the existence of a control group has been applied to glom on to a preexisting controlling stockholder additional stockholders to give them the status of a ‘control group.’” The Court explained that such an argument would not have merit unless the preexisting controlling stockholder agreed to limit its ability to act in its own self-interest as a controller in some material way (and thereby share control). The Court found no evidence of that here and dismissed these claims as well.