In a precedent-setting decision, In re Sears Hometown and Outlet Stores, Inc. Stockholder Litigation, 30 A.3d 474, 2024 WL 262322, at *1 (Del. Ch. Jan. 24, 2024), Vice Chancellor J. Travis Laster clarified for the first time the standard of review governing a controlling stockholder’s exercise of its voting rights. The Court of Chancery held that, when a controller uses its voting rights to change the company’s “status quo,” fiduciary duties attach—specifically, duties of loyalty and care. The specific question at issue in the action was whether the controlling shareholder’s use of his voting power to slow down a plan of liquidation and thereafter acquire the company himself breached his fiduciary duties. In addressing the issue, the Court held that, where a controller exercises its voting power and has a conflict of interest, enhanced scrutiny, rather than the business judgment rule, applies. The case is the first in Delaware to establish a fiduciary framework for actions taken by controlling stockholders qua stockholders, as opposed to actions they take to influence a board’s management to wield corporate power indirectly.
Background
Sears Hometown and Outlet Stores (“SHO”) operated through two business segments, one of which was failing. While SHO’s committee of independent directors determined that liquidating the failing business segment was in the company’s best interest, its controlling shareholder disagreed, believing that the committee’s liquidation plan would “destroy value.” After unsuccessfully attempting to dissuade the committee from pursuing the liquidation, the controller tried to stymie the liquidation by deploying his voting power to enact two separate changes by written consent (the “Controller Intervention”). First, he amended the Company’s bylaws to require that liquidation receive approval through two separate board votes, taking place at least thirty business days apart. Second, he removed two members of the board whom he saw as the main proponents of the liquidation plan. He filled these vacancies with individuals whom he did not control, but who he was confident would support his positions. These moves, the controller admitted at trial, were designed to slow down or prevent a liquidation.
With liquidation off the table, the board was forced to negotiate with the controller over an acquisition of the company. The controller agreed to a whole-company sale, with the profitable business segment subject to an 84-day go-shop period with a floor price and a capped matching right held by the controller. A third party purchased the profitable business segment for a value over the controller’s matching right cap, and the controller purchased the rest of the Company at a 76% premium over its share price.
Following the sale, various minority stockholders filed suit against the controller, alleging that he breached his fiduciary duties and challenging both the Controller Intervention and the terms of the sale.
Analysis
Controller Intervention
The Court of Chancery analyzed the challenges to the Controller Intervention and the fairness of the sale of the Company separately. As to the Controller Intervention, the Court of Chancery first grappled with the lack of controlling authority supplying a fiduciary framework. While prior Delaware authorities provided that some level of equitable review would apply where a controlling stockholder used its voting power to block a transaction, none supplied a framework for that equitable analysis. Some courts had held that, based on the general rule that stockholders can exercise their rights free of constraint, a controller could as well, and that fiduciary duties did not apply; others had found that fiduciary duties did apply “when a corporate decision implicates a controller’s duty of loyalty.”
To reconcile the competing strands of caselaw, V.C.Laster analyzed precedent governing controllers’ exercise of two familiar rights that accompany a share—the rights to sell and vote. With each, he found that a controller can exercise its rights to “maintain[] the status quo, without engaging in a fiduciary act.” For example, a controller can decline to sell stock to a looter, or vote in self-interest and maintain the status quo, without triggering any fiduciary obligations. But if the controller decides to change the status quo through the exercise of one of its rights as a shareholder, fiduciary duties attach, albeit limited ones: the controller cannot harm the corporation or its minority stockholders intentionally or through grossly negligent action. Because the Controller Intervention did change the Company’s status quo—by amending bylaws and replacing directors—the controller was subject to these limited duties of loyalty and care.
The court next considered what standard of review applied to assessing a breach. Absent on-point precedent, the Court analogized to the standards of review applicable to director actions, holding that enhanced review would apply in the present case, where the controller sought to amend bylaws and remove directors. In the director-action context, enhanced scrutiny applies when directors “intrude[] into a space where stockholders possess rights of their own,” such as when they “amend bylaws or otherwise intervene in elections or voting contests.” The court reasoned that, “[i]f enhanced scrutiny applies to one set of fiduciaries (directors) when they take action that affects the rights of a stockholder majority, it should also apply to a different fiduciary (a controller) who takes action to impair the rights of the directors or a stockholder minority.” Importantly, the court did not hold that enhanced review applies to all controller actions that change the status quo; it merely applies where a controlling exercises its voting rights as the controlling shareholder did here.
After applying enhanced scrutiny and asking whether the controlling shareholder “acted in good faith,” and whether he had “selected a reasonable means for achieving his legitimate objective,” the Court found no breach.
Company Sale
Had the inquiry ended there, the controlling shareholder would have prevailed. Addressing separately the controller’s self-interested acquisition of the company, the court reviewed the transaction under the entire fairness standard. The court found that there was neither a fair price nor fair dealing: the controller had not paid enough, and had, by enacting bylaws and replacing directors, unfairly tilted the playing field in his favor by decreasing the board’s negotiation leverage. “The deciding factor,” the court wrote, was “the Controller Intervention. Although [the controller] did not breach his fiduciary duties when taking that step, its ramifications fatally undercut the [board’s] ability to negotiate for fair terms.” The court therefore found that the controller had breached his fiduciary duties (despite the fact that he sincerely believed in the fairness of the transaction) and was required to pay over $18 million to the minority stockholders to compensate for the difference between the transaction price and the judicially-determined fair price.
Takeaways:
Sears provides important guidance to controlling stockholders who opt to exercising their voting power to alter the status quo of a corporation. Controlling stockholders should be aware that if they vote or sell their stock in a way that could be seen as altering the status quo, they are subject to fiduciary duties of loyalty and care, and will be expected to conform to these standards of care.
