Publications: Minority Stockholders Beware: There are limits on the duties owed by selling controlling stockholders to the remaining stockholders

As a controlling stockholder of a corporation, it is important to remember that Delaware law imposes a duty upon a selling controlling stockholder (i) to make such inquiry of a proposed buyer’s plans for the target company as a reasonably prudent person would make, and (ii) to generally exercise care. These actions should be taken to insure that the non-selling stockholders and others who will be affected by the selling controlling stockholder’s actions will not be injured by any resulting wrongful conduct (e.g., looting of the company by the buyer). Based upon this duty, the general rule is that a controlling stockholder is free to sell its stock for a premium not shared with the other stockholders except under very narrow circumstances.

In a recent Delaware case, Abraham v. Emerson Radio Corp., the Delaware Chancery Court addressed a claim against a sporting goods company’s controlling stockholder that sold its control block for a premium to a strategic buyer that also operated in the same market space. The complaint alleged that (i) the controlling stockholder had received payments in excess of the value of stock from the buyer, not for its majority interest, but as a payment for permitting the buyer to usurp the assets of the target company to the detriment of the minority/remaining stockholders, and (ii) the controlling stockholder had breached its duty of loyalty by permitting, aiding and abetting the buyer’s unfettered use and enjoyment of the target’s assets without fair compensation. Plaintiff’s allegations of buyer’s intent to plunder the target company were based, in part, on statements in the buyer’s press release to the effect that “this transaction places a multitude of valuable assets under (the buyer’s) managerial umbrella.”

Background

Sport Supply Group, Inc. (“Sports Supply”) was 53.2% owned by Emerson Radio Corp. (“Emerson”). Sport Supply voluntarily delisted its stock in early 2004 but continued to trade on the pink sheets. By late 2004, Sport Supply’s share price had risen from the $1-$2 range to $3 per share. By mid 2005, it was trading at $3.65 per share. On July 5, 2005, Emerson announced that it had sold its majority stake in Sports Supply for $32 million or $6.74 per share, an 86% premium to the prior day’s closing price, to Collegiate Pacific, Inc. (“CPI”), a competitor formed by Sport Supply’s founder and former CEO. On September 8, 2005, CPI announced that it had agreed to a stock-for-stock merger with Sport Supply pursuant to which the minority holders of Sport Supply (of which the plaintiff was one) would receive 0.56 of a share of CPI stock that was valued at the time of announcement at $6.74. Unfortunately, CPI’s share price began to drop as a result of increased acquisition costs and earnings dilution resulting from the conversion of outstanding notes into common equity, and the merger agreement was ultimately terminated. In the interim, a large institutional shareholder sold a significant block of Sport Supply stock to CPI for $5.50 per share in cash. By the time the complaint was filed, Sport Supply shares were trading at only $4.85 per share.


Scope of Duty

While quickly dismissing the complaint for failing to state a cause of action on which relief could be granted, the decision is of interest for various reasons including those set forth in dicta. First, the Court confirmed the general right of a controlling stockholder to sell its majority bloc for a premium not shared with other target stockholders, and second, the Court suggested additional limits on the potential liability of a controlling stockholder where the target’s certificate of incorporation contains an exculpatory provision authorized by Section 102(6)(7) of the Delaware General Corporate Laws (“Section 102(6)(7)”). This provision prohibits recovery of monetary damages from directors for a successful stockholder claim, either direct or derivative, that is exclusively based upon establishing a violation of the director’s duty of care. The Court held that, while the plaintiff had established that the controlling stockholder knew it was selling to a strategic buyer who would attempt to capitalize on possible synergies, this was not a breach of fiduciary duty.

In reaching its conclusion, the Court conceded that the precedent suggests that a selling controlling stockholder has the duty to make such inquiry as a reasonably prudent person would make, and generally to exercise care so that others who will be affected by his actions should not be injured by the wrongful conduct. Vice Chancellor Strine, however, went on to state that he was “dubious that our common law of corporations should recognize a duty of care-based claim against a controlling stockholder for failing to (in a court’s judgment) examine the bona fides of a buyer, at least when the corporate charter contains an exculpatory provision authorized by Section 102(b)(7).”

Vice Chancellor Strine noted the rule that the controlling stockholder owes fiduciary duties in its capacity as a stockholder is based upon the premise that such stockholder exerts its will over the enterprise in the manner of the board itself. When the board itself is exempt from liability for violations of the duty of care, as under a Section ‘102(b)(7) exculpatory provision, the Court suggested that it would be illogical to extend liability to a controlling stockholder exercising its ordinarily unfettered right to sell its shares. Vice Chancellor Strine continued, noting that the unthinking acceptance that a greater class of claims ought to be open against persons who are ordinarily not subject to claims for breach of fiduciary duty at all - stockholders - than against corporate directors is inadequate to justify recognizing care-based claims against sellers of control positions.

Vice Chancellor Strine also carefully noted that “drawing the line at care would do nothing to immunize a selling [controlling] stockholder who sells to a known looter or predator, or otherwise proceeds with a sale conscious that the buyer’s plans for the corporation are improper. But it would impose upon the suing stockholders the duty to show that the controller acted with scienter and did not simply fail in the due diligence process.”

Practical Take-Aways

The Court’s opinion gives some guidance for controlling stockholders and practitioners alike:

1. Include a Section 102(b)(7) exculpatory provision in the corporate charter. The Court’s analysis of how a Section 102(6)(7) provision may impact the duties of a controlling stockholder is significant. While most corporations include such a provision in a Delaware corporate charter, it is not unusual for this to be overlooked and inadvertently left out. Any company without a Section 102(b)(7) exculpatory provision should promptly seek to amend its charter so that its directors and, if applicable, controlling stockholder(s) can have the benefits of such a provision.

2. Know your buyer. While a controlling stockholder will not incur liability for an incomplete due diligence process regarding the buyer of its majority stake, controlling stockholders should be aware that they are not immune from liability where the buyer’s plans for the controlled company rely on a strategy of seeking corporate synergies. Regardless of whether an exculpatory provision is included in the charter, a duty of care claim may stick in situations where the controlling stockholder knows that its stake is being sought by a “looter” or where it is aware that the buyer is dishonest and may injure the remaining stockholders.

3. Know your duties and obligations. Prior to initiating a sale, selling controlling stockholders should be sure to review any applicable stockholder agreements for provisions precluding or otherwise restricting their ability to sell or the terms on which they may sell their stock. In addition, in order to avoid conflicts of interest with the company itself or the other stockholders, a controlling stockholder should engage its own independent counsel. In such situations, the interests of the controlling stockholder are frequently at odds with those of the other stockholders, and often the company as well.

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