Minority Shareholders and Board Domination

The following post comes to us from Daniel J. Dunne, partner in the Securities Litigation & Regulatory Enforcement Practice Group at Orrick, Herrington & Sutcliffe LLP, and is based on an Orrick publication by Mr. Dunne and Peter J. Rooney. This post is part of the Delaware law series, which is cosponsored by the Forum and Corporation Service Company; links to other posts in the series are available here.

Emphasizing the demanding pleading standards a shareholder must meet to show that a minority shareholder controls a board of directors, on November 25, Vice Chancellor Glasscock dismissed claims for breach of fiduciary duties against the directors of Sanchez Energy Corporation in connection with a corporate acquisition of assets. The decision in In Re Sanchez Energy Derivative Litigation, C.A. No. 9132 VEG, reinforces the Chancery Court’s insistence that shareholder plaintiffs plead specific facts to raise reasonable doubts whether directors lack independence, especially when it comes to longstanding personal and business relationships. To sustain a claim that minority shareholders exercised domination and control over a board of directors, plaintiffs must plead specific facts demonstrating actual control of the board in the transaction at issue in the lawsuit.

Background of the Transaction

In August 2013, Sanchez Energy Corporation (the “Company”) entered into a joint venture transaction (the “Transaction”) with Sanchez Resources, LLC (“Sanchez Resources”) for the purchase of “working interests”—rights to develop land and extract oil, subject to royalty payments owed to landowners—in Sanchez Resources’ “Tuscaloosa Marine Shale” (“TMS”) project. Sanchez Resources was controlled by two members of the Company’s board of directors, Sanchez Jr. and Sanchez III, so the Sanchez’s were interested in the transaction.

The Company’s board was composed of five directors, including Sanchez Jr. and Sanchez III, who jointly owned 21.5% of the Company’s stock. The Transaction was approved by the Company’s Audit Committee, based on the authority delegated to it in the Audit Committee Charter. The Audit Committee was composed of the other defendant directors of the Company—Jackson, Garcia and Colvin—none of whom had a financial interest in the Transaction.

Plaintiffs’ Allegations and the Court’s Decision

The stockholder plaintiffs asserted derivative claims for breach of fiduciary duty, and related claims, against the Company and its five directors. Plaintiffs alleged that Sanchez Jr. and Sanchez III (the “Sanchez family”) caused the Company to engage in a one-sided asset transaction with Sanchez Resources, the entity controlled by the Sanchez family. The plaintiffs did not avail themselves of their rights to inspect the Company’s books and records under DGCL Section 220. As a result, the court concluded, the complaint contained no allegations about the course of negotiations between the Company and the other parties to the Transaction.

The plaintiffs did not make a demand on the Company’s board to take action with respect to the Transaction. Instead, the Plaintiffs argued that demand was futile and should be excused under both prongs of the Aronson test—that the board of directors lacked independence from the Sanchez family, and that the financial terms were so facially unfair to the Company that the Transaction was not entitled to business judgment deference.

The Court granted defendant’s motion to dismiss because plaintiffs had not pled facts sufficient to raise a reasonable doubt as to either of the two Aronson prongs.

Longstanding Business Relationships and Friendships Did Not Deprive The Audit Committee of Independence

First, Vice Chancellor Glasscock rejected challenges to the independence of directors Jackson and Garcia based on conclusory allegations about their longstanding familial ties and friendships lasting three to five decades. Plaintiffs had not alleged specifically the nature and extent of these friendships and how they would impact director decision-making. The fact that Jackson had donated $12,500 to Garcia Jr.’s gubernatorial campaign, standing alone, was not sufficient. The court was also unmoved by plaintiff’s argument that director Jackson was “beholden” to the Sanchez family because Sanchez Jr. had the power as a director of a parent company to affect Jackson’s livelihood and income as an executive at the parent company’s insurance subsidiary. In short, plaintiffs had not supplied specific allegations to show that Sanchez Jr., as director of a parent, could directly affect Jackson’s livelihood.

As to director Garcia, the court found that pleading that he and the Sanchez family were co-investors in two entertainment and music publishing ventures was inadequate to impugn Garcia’s independence. Even indulging some potential inferences about the desire to curry favor with co-investors, plaintiffs failed to place Garcia’s co-investments in a meaningful context, failed to explain the significance of the financial relationships and failed to allege their materiality to Garcia’s financial status. As a result, plaintiffs’ conclusory allegations were not adequate to show that either Jackson or Garcia lacked independence when they voted to approve the Transaction as members of the Audit Committee.

Second, Vice Chancellor Glasscock also found inadequate the conclusory allegations that the Sanchez family, which owned 21.5% of the Company’s voting interests, “dominated and controlled” the board of directors. Reviewing some of the Chancery Court’s recent decisions in this area, [1] Vice Chancellor Glasscock reiterated that the test for domination and control by a minority shareholder was quite clear—that pleading facts showing actual control of the board’s decision in the transaction at issue “is the defining and necessary feature of a minority controlling shareholder.” Bringing sharp focus to the control over the Transaction, allegations about how the Sanchez family exercised direct control over day-to-day management and operations of the Company were irrelevant, especially given plaintiffs admission at oral argument that the Sanchez family lacked the power to remove a director who displeased them.

Continuing the Court of Chancery’s strong emphasis on pre-litigation statutory discovery, the court castigated plaintiffs for failing to pursue Transaction documents through a Section 220 books and records request. The Company was not subject to public company reporting obligations, and as a result of Plaintiffs’ decision to sue first, the court observed that plaintiffs had deprived themselves of any opportunity to obtain facts about the negotiation, review and approval of the Transaction. Plaintiffs were thus disabled from pleading facts to show actual control of the board in the Transaction.

The Transaction Was Not “Facially Unfair” and Subject to Entire Fairness Review

Finally, Vice Chancellor Glasscock rejected plaintiffs’ argument that the terms of the transaction were so “facially unfair” as to raise a reasonable doubt whether it was undertaken “honestly and in good faith.” The court noted that the standard for finding a transaction to be facially unfair is tantamount to corporate waste, but that plaintiffs here could not allege waste because the Company had received value for value. The court rejected several proposed comparisons intended to show that the Transaction was “staggeringly unfair.” The fact that Sanchez Resources had paid only $184/acre for interests that it was selling to the Company for $2,500/acre failed to account for the fact that the acreage was now developed and contained proven reserves, thereby justifying a large increase in price. Similarly, plaintiffs failed to allege facts to show that a transaction on an adjacent parcel for less than 10% of the consideration paid by the Company was comparable to the Transaction. Additional allegations that “nefarious motives” could be inferred from the Company’s alleged withholding of information or purported admissions were also rejected.

Takeaways

In re Sanchez treads familiar ground in the area of director independence in the context of transactions with substantial, but non-majority stockholders, but that tread is now better defined in several respects.

  • The Court of Chancery continues its insistence on pleading of specific facts to show demand futility, rejecting conclusory and generalized allegations about longstanding business relationships and friendships to overcome a presumption of director independence.
  • With respect to minority shareholder control, the court reiterates that the focus must be on actual control of the board’s action in the transaction at issue, declining again to infer domination from minority shareholders’ control of corporate management and operations.
  • Finally, the court refuses to infer bad faith from apparent disparities between similar transactions—even extremely large disparities—if they are not accompanied by sufficiently detailed analyses establishing that the transactions are comparable. Showing such comparability may require the type of sophisticated financial analyses typically performed by financial advisors.

In re Sanchez highlights that the Court of Chancery remains unwilling to indulge inferences from general allegations in demand futility cases, and lacks patience for plaintiffs who fail to avail themselves of their Section 220 rights before filing suit.

Endnotes:

[1] The court relied particularly on two recent decisions in In Re Crimson Exploration Inc. Stockholder Litig., C.A. No 8541-VCP (Del. Ch. Oct. 24, 2014) and In re KKR Financial Holdings LLC Shareholders Litig., C.A. No. 9210-CB (Del. Ch. Oct. 14, 2014).
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