Investors with significant minority stakes in publicly traded companies face an increased risk of deal litigation based on theories of imputed control. Until recently, a non-passive, significant minority investor with limited representation on a company’s board of directors could—absent abusive conduct—reasonably expect that it would not be deemed to be a controlling shareholder in M&A litigation as long as it held significantly less than the 50 percent of outstanding stock required for voting control. In the past few years, however, plaintiffs have brought a series of cases challenging that assumption, and have sought to impute control—and with it, a higher standard of review—to transactions involving significant minority stockholders. In these cases, plaintiffs claim that the transaction was conflicted and unduly benefitted the alleged controller, and as a result, the court should subject the deal to Delaware’s searching “entire fairness” review rather than deferring to the business judgment of the directors.
While the law continues to evolve, a number of judges on the Chancery bench have credited allegations that a sophisticated financial investor—often a private equity fund—that held only a minority stake in a public company exercised such disproportionate influence as to be practically in control for purposes of a transaction, particularly when that transaction appears to favor the fund. Increasingly, these allegations are surviving motions to dismiss, sending more cases into intensive (and expensive) fact and expert discovery over the key questions of fair price and fair process, and the existence of “actual” control, notwithstanding the minority voting stake.
This trend means that investors who had reasonably concluded they were merely a minority stockholder, able to vote and transact in their own interest, have increasingly found themselves embroiled in long-running litigation that just a few years ago would have been dismissed on the pleadings. The change in Delaware law compels such investors to consider whether they should adopt deal protections typically reserved for transactions with an obvious controller.
This newly expansive view of “actual control” is a troubling development for transactions with significant minority stakeholders, and one that private equity investors and their advisors should keep in mind when engaged in public company transactions that fit plaintiffs’ target profile. To that end, we provide below a brief primer on the evolving law and tools for risk mitigation.
Fiduciary Duties and Allegations of Investment Fund Liability
Stockholders are generally free to act in their own interests. However, “controlling” stockholders owe fiduciary duties, which compel the controlling stockholder to act in the interests of the corporation and the other stockholders. Courts assign fiduciary duties to controlling stockholders because a controlling stockholder essentially controls the company and the board’s decisions, and the controlling stockholder’s decisions may well affect the rights of the unaffiliated stockholders.
Although a stockholder that owns more than 50 percent of the voting shares of a corporation always is a controlling stockholder with the attendant fiduciary duties, a minority stockholder too can be considered a controlling stockholder. For this to happen, the minority stockholder must have either: (1) dominated and controlled the company or its board with respect to the transaction at issue, or (2) exercised considerable voting and managerial power over the company’s day-to-day decisions. Under prior case law, an alleged controller with a minority stake usually had to be plausibly abusive or oppressive in order for a court to impute control.
For example, courts have looked to actions such as:
- freely removing and replacing board members seemingly not affiliated with the minority stockholder,
- significant influence over or very close relationships with other members of the board,
- threats of a hostile takeover, or
- the exercise of contractual rights to push the company into a “comply or die” situation, in which surrender to the minority stockholder is the only way to avoid placing the company into a dire financial situation, such as bankruptcy.
Recently, however, this behavioral threshold has been lowered, with courts relying on less abusive or explicit conduct to conclude, at least at the motion to dismiss stage, that a minority holder could be a controller. Minority holders with a material voting stake are particularly at risk. Even where judges’ opinions cite alleged misconduct in recounting the facts, courts express the legal standard in generic terms indicating that abusive conduct by the stockholder is not necessary. These opinions make clear that at least some judges on the Chancery bench look to the general “gestalt” of control instead of requiring specific allegations of misconduct.
If a court finds that the complaint sufficiently establishes imputed control, the transaction is not protected by the business judgment rule and the mere approval by a majority of independent stockholders will not have a cleansing effect under Corwin. Instead, the court will allow the case to proceed to discovery under a presumptive “entire fairness” review, which looks closely at the transaction to determine whether the price and the process were fair. If, after trial, a court is not satisfied in this regard, it has broad powers to fashion an equitable remedy. A court may, for example, determine the price at which the transaction should have happened, and award the difference between that figure and the actual price, which can result in substantial adverse judgments.
Potential Sponsor Liability
Complaints seeking to impute control to an investment fund with a significant minority stake typically do not distinguish between the fund and its sponsor—and neither do the courts’ decisions. Especially on the pleadings, Delaware courts have been willing to collapse the distinction between the fund and its manager, and to credit allegations that together they act as the alleged controlling stockholder—even though fund sponsors and management companies are rarely direct investors in public companies. Rather than differentiating between the stock ownership of the sponsor or management company and that of the fund, courts have credited allegations that since the same people sit at the fund and sponsor level, the two entities are indistinguishable for the purposes of determining control. This is a disturbing development for sponsors, which increasingly face claims despite their lack of direct investment or representation, and obscures the meaningful differences between the investment vehicle and its contractual investment manager.
To mitigate the risk of being labeled a controlling stockholder, investors should start by recognizing the surprisingly low investment thresholds at which those risks start to accrue, and approach the transaction with an eye toward how those risks might materialize in litigation.
One powerful strategy for investors to follow is implementing the rigid procedure discussed in MFW that seeks to insulate the transaction from a controller’s influence and, at least in principle, guarantees business judgment review of the transaction. An investor must implement two key conditions to ensure that it is covered by MFW’s protections when entering into a transaction. Specifically, prior to the start of economic negotiations, the investor must condition the transaction on approval by both (1) an independent special committee and (2) a majority vote by fully informed minority stockholders. Those charged with constituting such a special committee should identify any connections between the potential controller and the individuals on the special committee in order to avoid allegations that the committee could not sufficiently protect the transaction from the controller. Similarly, the special committee should carefully screen its advisors for any potential conflicts with the minority stockholder that might lead a court to later infer that the special committee did not receive unbiased advice.
If MFW is properly followed, any lawsuit challenging the transaction will have a higher chance of being dismissed before discovery. Although implementing the MFW procedures may have a cost in terms of the transaction’s speed and certainty, those costs must be balanced against litigation risk at a time when courts are more willing to tag a minority stockholder as a controller.
However, it is important to note that putting MFW protections in place will not eliminate the risk of a claim surviving a motion to dismiss. That is because the adequacy of the MFW procedures requires factual determinations, and plaintiffs can often allege facts—such as those questioning the independence of the special committee or the adequacy of disclosures to the unaffiliated stockholders—that prevent a court from determining at the motion to dismiss stage that the MFW conditions were properly implemented. For that reason, an investor should anticipate that plaintiffs will use discovery to explore the underlying facts should MFW fail at the motion to dismiss stage.
While there may be countervailing business considerations, an investor can also mitigate the risks of being found a controller in the first place by putting in place contractual arrangements that limit the investor’s influence over the company, such as by restricting the number of fund-affiliated directors on the board or expressly requiring independent directors’ approval of certain transactions and matters. By the same token, an investor should consider contractual arrangements as a source of risk where they appear to provide the investor with an edge in governance or decision-making.
Although minority investors need to recognize the increased litigation risk they face, that risk can be mitigated and need not prevent desirable transactions. Litigation risk, properly understood and managed, may often be preferable to the deal risk of acting too defensively—particularly while the law regarding minority controlling shareholders remains somewhat uncertain. Sophisticated investors can address these challenges by identifying them at the start of the deal process and adjusting their strategy accordingly.