Chancery Court Suggests Rights Offerings May Limit Liability in Certain Transactions

When a corporation sells corporate assets to its (or an affiliate of its) controlling stockholder, Delaware courts generally will review that transaction under the exacting “entire fairness” standard. [1] But what if the corporation’s minority stockholders are given the opportunity to participate along with the controlling stockholder in the purchase of the corporate assets pro rata to the extent of their stock ownership?

That question was discussed by Vice Chancellor Laster of the Delaware Court of Chancery at a hearing last month to approve a settlement in In re Sears Holdings Corporation Stockholder and Derivative Litigation, C.A. No. 11081-VCL. At that hearing, Vice Chancellor Laster suggested that regardless of the standard of review to be applied, and absent any coercion in the rights offering or unique benefit to the controlling stockholder, defendants would have no liability to the stockholders who participated in the rights offering and—at most—would be liable to the non-participating stockholders. We note that these comments were made from the bench at an uncontested settlement hearing, and there is no guarantee that the Court of Chancery would reach the same conclusion in contested litigation. But, if followed, this rule may provide a significant safe harbor for transactions involving controlling stockholders.

In re Sears was a shareholder derivative action brought by certain Sears stockholders to challenge a July 2015 transaction in which Sears sold 235 of its stores to a newly formed, publicly-traded REIT called Seritage for a purchase price of approximately $2.3 billion. At the time of the transaction, Sears was approximately 50% percent owned by Edward S. Lampert and ESL, an investment fund managed by Mr. Lampert, who is also the chairman and CEO of Sears. The equity portion of Seritage’s capitalization was raised via a rights offering as follows:

• All Sears’ stockholders were given the opportunity to acquire Seritage shares at the same price.
• The rights were transferable (and were traded on the New York Stock Exchange), so a stockholder who did not wish to exercise could capture the value of the rights by selling them into the market.
• ESL fully exercised its rights, and virtually all of the rights distributed to other stockholders were also exercised (in aggregate, over 97% of the rights were exercised).
• As a result of ownership limits required for Seritage to qualify to be taxed as a REIT, ESL had to take most of its equity stake in Seritage in the form of illiquid partnership units in a Seritage subsidiary, which were non-voting, although they contained certain veto rights. Thus, as the court expressly assumed at the settlement hearing, ESL and Mr. Lampert were in no better position vis-à-vis the real estate assets at Seritage than they were at Sears, and possibly, they were worse off.

Plaintiffs nonetheless alleged that (1) this transaction constituted self-dealing because ESL and Mr. Lampert effectively stood on “both sides of the deal” and, as a result, the court should review the transaction for entire fairness, and (2) the transaction was not entirely fair to Sears because the purchase price for its stores was $300 million too low. Plaintiffs also alleged that ESL, Mr. Lampert, Sears’ board, and Seritage (the last as an alleged aider and abettor) were jointly and severally liable to Sears for this purported $300 million shortfall.

Before defendants filed a motion to dismiss, the parties entered into a settlement in which defendants agreed to pay $40 million to Sears. A hearing on plaintiffs’ motion to approve the settlement was held on May 9, 2017 before Vice Chancellor Laster. At the hearing, the court questioned plaintiffs’ counsel whether the complaint alleged any real harm to Sears’ stockholders other than, at most, the 3% who did not receive Seritage shares as a result of the rights offering. For example, the court asked whether ESL received more control or greater “cash flow rights” in Seritage than it had in Sears, but plaintiffs’ counsel was unable to articulate such a theory on the facts of that case. The court also noted that “[a]ll rights offerings are not created equal,” [2] and asked whether the rights were tradeable (they were). The case thus boiled down to plaintiffs’ theory that defendants were liable to Sears for the entire alleged $300 million underpayment, regardless of the fact that 97% of the equity in Sears was also on the other side of that transaction (via the exercise of rights to acquire Seritage equity) and thus was indifferent as to price.

During the settlement hearing:

• The court expressed “concern” that the plaintiffs’ theory “elevates form over substance to a degree that, at least historically, has been inconsistent with how a court of equity looks at transactions.” [3]
• Without “hazard[ing] any guess” about what standard of review would apply, [4] the court observed that “quite likely there is none or minimal harm here,” [5] as damages (if any) would most likely be capped at 3% of the alleged underpayment (assuming such underpayment were proven) to account for the fact that the remaining 97% of stockholders were not harmed at all. [6]
• The court noted that it is nonetheless “entirely rational for the defendants to settle this case as they did, because … [w]e’re talking about litigation that would cost far more to defend than settle,” particularly because the economic cost of the settlement to the defendants was much less than the nominal $40 million, since much of the payment was “moving money from one pocket to another.” [7]
• The court reduced plaintiffs’ requested fee award from $6 million to $4 million, saying it was already generous and, having found that the suit could be seen as a “strike suit” which should not be incentivized, did not want to encourage such suits being brought in the future. [8]

Although it is important to emphasize that these comments were made at an uncontested hearing, Vice Chancellor Laster’s analysis suggests that potential liability in transactions with controlling stockholders can be substantially reduced (if not eliminated) if (1) the transaction is structured so that minority stockholders are able to participate pro rata with the controlling stockholder (e.g., as a rights offering with any rights issued being transferable), (2) there is no other alleged coercion, and (3) the controller does not receive any unique benefit at the expense of the minority. [9]

Endnotes

1That is, unless the requirements of Kahn v. M & F Worldwide Corp., 88 A.3d 635 (Del. 2014), are met, in which case the transaction will be reviewed under the more lenient business judgment rule. See In re EZCORP Inc. Consulting Agreement Derivative Litig., 2016 WL 301245, at *11 (Del. Ch. Jan. 25, 2016).(go back)

2Transcript of May 9, 2017 Hr’g at 9.(go back)

3Id. at 28.(go back)

4Id. at 29. The defendants’ position was that “entire fairness” review would not have been appropriate in any case since there was no “self-dealing” involved in the transaction because the ESL parties did not receive any unique benefit at the expense of minority stockholders. See Stepak v. Tracinda Corporation, 1989 WL 100884, at *2 (Del. Ch. Aug. 21, 1989) (concluding that, although transaction had controlling stockholder on both sides, its structure as a rights offering allowing for equal participation by minority stockholders “could be seen as treating all stockholders similarly and thus to lose its self-dealing aspects,” making it “unimportant whether [the price] was ‘entirely fair’”).(go back)

5Id. at 29-30.(go back)

6The defendants would have argued that there were no damages even in respect of the 3% unexercised rights since the initial holders of the rights could (and some may in fact) have captured the value embedded in the rights by selling them in the market.(go back)

7Id. at 31.(go back)

8Id. at 31-33.(go back)

9Cleary Gottlieb represented ESL and Mr. Lampert in the litigation and settlement.(go back)