Delaware Court Further Clarifies Definition of Controlling Stockholder

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By Michael Greene

Nov. 25 — Directors who own a substantial amount, but less than 50 percent of the corporation's stock are not controllers, even when they stand on both sides of a conflicted transaction, unless they exercise actual control over the board, according to a Nov. 25 Delaware Chancery Court opinion.

Vice Chancellor Sam Glasscock III opined that “actual control of corporate conduct mean actual control over the corporations's board of directors in the transaction at issue.”

Looking at its recent decisions, the court concluded that two interested directors were not controllers of the transaction at issue and that the plaintiffs failed to plead demand futility.

Conflicted Transaction?

Plaintiff stockholders filed a derivative lawsuit against Sanchez Energy Corp.'s board of directors alleging a breach of fiduciary duty arising from a transaction in which the corporation purchased assets from a shell entity controlled by two members of Sanchez energy's board. The transaction, however, was approved by an audit committee consisting of the company's three other board members.

Because the plaintiffs did not make a pre-suit demand on the board, the defendants filed a motion to dismiss. The plaintiffs argued that demand should be excused because two of the three disinterested directors lacked independence and the transaction was not a product of a valid exercise of business judgment.

Disinterested and Independent

The plaintiffs conceded that all three members of the audit committee were financially disinterested. They instead argued that two of the three directors on the committee lacked independence because of their business and financial relationships with the interested board members.

Vice Chancellor Glasscock noted that to establish that a director lacked independence from a person based upon an ongoing relationship, “the nature of that relationship must be of a kind that would support a reasonable inference that the ‘non-interested director would be more willing to risk his or her reputation than risk the relationship with the interested director.'”

The court found that the plaintiffs' complaint lacked specific allegations to support a reasonable inference that two disinterested directors lacked independence. More specifically, there were no allegations as how the personal and business relationships caused the director to abandon their fiduciary duties.

Not Controlling Stockholders

The court next addressed whether demand should be excused because the transaction at issue was not the product of a valid exercise of business judgment. The plaintiffs argued that the transaction should be evaluated under the entire fairness standard because the two interested directors should be treated as controlling stockholders.

Vice Chancellor Glasscock noted that two recent Delaware Chancery Court opinions—In re KKR Financial Holdings, LLC Shareholders Litig. and In re Crimson Exploration Inc. Stockholders Litig.—reaffirmed the view that “minority Stockholders are controllers only where they exercise actual control over board.”

Glasscock opined that the In Re Crimson decision confirms that there is “no linear, sliding scale” approach that makes it more likely that a court will find a stockholder controlling. Instead, “actual board control in the transaction at issue is undoubtedly the defining and necessary feature of a minority controlling stockholder.”

In this case, the court found that the plaintiffs' allegations did not support an inference that the interested directors were controlling stockholders.

The plaintiffs claimed that the directors exercised actual control over the operations of the company because of their collective 21.5 percent stake in company and the fact that one of the directors was the company's CEO.

Vice Chancellor Glasscock determined that there was no facts to support that the CEO director exercised “any greater control than that typical of a CEO,” and there was no evidence that he dominated or controlled the board.

He additionally found persuasive that the directors could not exert power to remove a dissenting director.

Books & Records

The plaintiffs additionally suggested that one of the interested directors controlled the negotiations process and strong-armed the deal past the audit committee.

Vice Chancellor Glasscock found that he had no basis to know to what extent any of the directors participated in the negotiation process. Here, the plaintiffs chose not to make a books and records demand on the board to uncover document relating to the negotiating process.

“This Court and our Supreme Court have regularly cautioned stockholder plaintiffs of the dangers of moving forward with derivative suits without first taking advantage of the informational tools available to them —particularly Section 220 [of the Delaware General Corporation Law],” Vice Chancellor Glasscock opined.

He found that the plaintiffs were not entitled to any inferences regarding the negotiation process because there were no facts that supported the argument that the interested director directed the terms of the agreement.

To contact the reporter on this story: Michael Greene in Washington at mgreene@bna.com

To contact the editor responsible for this story: Ryan Tuck at rtuck@bna.com

The opinion is available at http://courts.delaware.gov/opinions/download.aspx?ID=215170.