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E-MailAndrew W. Stern is partner at Sidley Austin LLP. This post is based on his Sidley memorandum, and is part of the Delaware law series; links to other posts in the series are available here.
Every once in a while, a court admits it made a mistake. And, in even rarer circumstances, that admission comes from a court as prominent as the Supreme Court of Delaware. But that’s exactly what happened last week in Brookfield Asset Management, Inc. v. Rosson, in which Delaware’s highest court overruled its own 2006 holding in Gentile v. Rosette that certain claims of corporate dilution are “dual-natured” and may be pursued both as derivative claims and as direct claims by stockholders. The Court’s decision to revisit a much-criticized decision is likely to restore some predictability and analytic consistency to the resolution of an important and threshold question frequently presented in stockholder litigation: whether a claim is properly characterized as direct (on behalf of one or a class of a company’s stockholders) or derivative (on behalf of the company itself).
Rosson arose from a private placement of common stock issued by TerraForm Power, Inc., at the time a public company controlled by a 51% stockholder. The controller purchased all of the newly issued stock, increasing its economic interest and voting power to 65.3%. Plaintiffs TerraForm common stockholders filed a derivative and class action complaint alleging that the stock had been issued for inadequate value, diluting the financial and voting interests of the minority stockholders and also damaging the company. Subsequent to the filing of the complaint, the controller acquired the balance of TerraForm shares that it did not already own, which under well-established Delaware precedent extinguished the ability of former TerraForm stockholders to pursue derivative claims. On defendants’ motion to dismiss the remaining direct claims, Vice Chancellor Sam Glassock noted that the type of claim at issue was classically derivative under Delaware jurisprudence: “the quintessence of a claim belonging to an entity: that fiduciaries, acting in a way that breaches their duties, have caused the entity to exchange assets at a loss.”
Notwithstanding this observation, the trial court nevertheless concluded that plaintiffs also had stated direct claims under the Supreme Court’s Gentile precedent in which similar allegations were found to have alleged “two independent harms…: (1) that the corporation was caused to overpay (in stock) for the debt forgiveness, and (2) the minority stockholders lost a significant portion of the cash value and voting power of the minority interest.” Although the Vice Chancellor expressed his view that the analysis of this “dual natured claim” was unsatisfying, he concluded that the trial court was “not free to decide cases in a way that deviates from binding Supreme Court precedent.”
On an unusual interlocutory appeal, the Supreme Court took the opportunity to revisit its precedents addressing the question of direct vs. derivative claims, including the 15-year-old Gentile opinion. After a long and detailed discussion of prior decisions, the Court reaffirmed the test articulated in its 2004 Tooley opinion.
Under the Tooley test, the determination of whether a stockholder’s claim is direct or derivative must turn solely on the following questions: (1) who suffered the alleged harm (the corporation or the stockholders, individually); and (2) who would receive the benefit of any recovery or other remedy (the corporation or the stockholders, individually)?
In Gentile, addressing a claim that a share issuance to a controlling stockholder had improperly diluted the minority, the Supreme Court had nonetheless permitted direct claims to go forward, reasoning that “there were two independent aspects of the plaintiffs’ claims, i.e., the overpayment claim and the minority’s loss of value and power.” According to Gentile, the plaintiffs had alleged not only harm to the corporation but also “an entitlement that may be claimed by the public shareholders directly and without regard to any claim the corporation may have.”
The Rosson court found that the so-called “Gentile carve-out” had proven to be unworkable and was, in any event, unnecessary because “[o]ther legal theories, e.g., Revlon, provide a basis to address fiduciary duty violations in a change of control context.” Moreover, the Court noted that “Gentile creates the potential practical problem of allowing two separate claimants to pursue the same recovery,” a result that would be barred by the so-called “double recovery rule.” The Court took pains to underscore the importance of stare decisis—adherence to precedent—noting that the Court’s prior decisions “should not be overturned by narrow majorities and very recent precedent should not lightly be overturned when the only change is the composition of the court.” The Court, however, satisfied itself that Gentile is “old enough … that we can properly say that the practical and analytical difficulties courts have encountered in applying reflect fundamental unworkability and not growing pains, but not so old as to carry the weight of ‘antiquity.’” Just as important, the Court pointed out that its decision was unanimous and thus would provide ample certainty to litigants.
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The question of whether a claim is properly characterized as direct or derivative is far from academic: it is often case-dispositive, as it was in Rosson, where all derivative claims were extinguished by the subsequent transaction that eliminated all public stockholders of TerraForm. After the Supreme Court had seemingly established an understandable and workable standard in Tooley, its decision in Gentile just two years later has led to continued uncertainty around claims based upon allegations of corporate dilution. The Supreme Court’s acknowledgement of this problem and its willingness to reassess the analytical framework will benefit defendants in circumstances in which a derivative claim cannot be pursued.
