Delaware Supreme Court Upholds Board Action that Has a Disenfranchising Effect on a Stockholder

Coster v. UIP (June 28, 2023) is the first decision (so far as we know) in which a Delaware court, in the context of a contested board election, has validated a board of directors’ action that had the effect of disenfranchising a stockholder. Notably, the case presented a highly unusual factual setting. In the decision, the Delaware Supreme Court addressed the overlapping applicability of the Schnell, Blasius and Unocal standards in this context and, combining these doctrines, established a unitary standard for review of board actions that have a disenfranchising effect.

Key Points

• The new standard appears to be, essentially, a heightened Unocal standard. Under the new standard, a board action that has the effect of disenfranchising a stockholder in the face of a contested director election or stockholder vote touching on board control is permissible if it is a “reasonable and proportionate” response to a threat to the corporation (the Unocal standard), but the court will apply the “special sensitivity” toward stockholder disenfranchisement issues that the Schnell and Blasius doctrines bring. The decision furthers the Delaware courts’ longstanding trend of blending these doctrines, with the effect, clarified in UIP, of essentially relegating Schnell and Blasius to being specific applications of the Unocal standard rather than being standards of review themselves.
• In our view, there will still be a very high bar to judicial validation of board action that has the effect of disenfranchising a stockholder in the face of a contested director election or stockholder voting touching on board control. The standard of review the Supreme Court articulated in UIP may appear to be less stringent than the Schnell and Blasius standards that have often been applied in this context. However, we believe it likely that the new standard will not significantly change the court’s general approach to or outcome in these cases—first, because the decision just reaffirms the court’s evolution toward a combination of the Schnell, Blasius and Unocal doctrines in this context; and, second, because, as the Supreme Court emphasized, the facts in UIP were highly unusual.

Background. UIP was owned 50% by Steven Schwat (a co-founder of the company) and 50% by Marion Coster (the widow of UIP’s other co-founder). Coster had inherited her husband’s shares by intestate succession. The UIP board knew that Coster’s husband had intended to provide for her to receive significant income after his death, and that she needed liquidity because he died before his estate documents were finalized. The board thus had been discussing options with Coster to achieve liquidity for her, including the company buying out her shares. The board could not reach agreement with her, however, given the price she was demanding for her shares (which was thirty times the value the Court of Chancery had determined).

UIP’s five-seat board was comprised of Schwat, Peter Bonnell (a longstanding key UIP employee), and UIP’s CFO, with two vacancies. Both times that Coster tried to call special stockholder meetings to elect directors to fill the board vacancies, Schwat and Coster deadlocked. Coster then filed an action with the Court of Chancery for appointment of a custodian for UIP, who could break the deadlock (the “Custodian Action”). In response, and in light of the failure of the negotiations with Coster over a buyout of her shares, the board decided to sell outstanding but unissued UIP stock, representing a one-third equity interest in UIP (the “Stock Sale”), to Bonnell (to whom equity had long been promised). The Stock Sale diluted Coster’s and Schwat’s respective ownership interests; broke the deadlock (with Schwat and Bonnell siding together against Coster); and mooted the Custodian Action. Coster sued, seeking cancelation of the Stock Sale, on the grounds that it was an attempt to interfere with her voting rights and block her from exercising her statutory right to seek the appointment of a custodian.

Court of Chancery 2020 decision. In a post-trial opinion, the Court of Chancery applied the entire fairness standard of review to the Stock Sale (given Schwat’s and Bonnell’s conflicts of interest relating to the Stock Sale). Then-Vice Chancellor (now Chancellor) Kathaleen St. Jude McCormick found that the entire fairness standard was met (that is, that the Stock Sale was effected at a fair price after a fair process). She also held that, as entire fairness is Delaware’s most exacting standard of review, additional review under any other standard (such as enhanced scrutiny under Schnell or Blasius) was unnecessary.

Delaware Supreme Court 2021 decision. On appeal, the Supreme Court concluded that the Court of Chancery had erred in evaluating the Stock Sale only under entire fairness. The Supreme Court emphasized that, even though the price and process may have been entirely fair, issuing stock while a contested board election was taking place had interfered with Coster’s voting rights as a half-owner of UIP; and, therefore, the lower court also should have evaluated the Stock Sale under Schnell (if the board’s primary motivation was to affect the stockholder franchise) or Blasius (if the board had had pure motivations for the Stock Sale). The Supreme Court remanded the case back to the Court of Chancery to reassess: whether the board had approved the Stock Sale for inequitable reasons; if not, whether the board, even if it had acted in good faith, had approved the Stock Sale to thwart Coster’s leverage to vote against the board’s director nominees and to moot the Custodian Action; and, if so, whether the board had demonstrated a compelling justification to interfere with Coster’s voting rights.

Court of Chancery 2022 remand decision. On remand, the Court of Chancery concluded, based on its prior findings as well as additional fact-findings, that the UIP board was primarily properly motivated. The court thus applied Blasius, and found that standard met as the board had “compelling justifications” for the Stock Sale. Coster appealed again, arguing that the Court of Chancery should have applied Schnell rather than Blasius as the board had been “primarily motivated” to dilute Coster’s voting power.

Delaware Supreme Court 2023 decision. The Supreme Court, in an opinion written by Chief Justice Collins J. Seitz Jr., found that the Court of Chancery had not erred in its remand decision; and, in any event, that the Stock Sale met the new standard the Supreme Court articulated. Coster’s claims were dismissed.

Discussion

The Schnell, Blasius and Unocal doctrines. Under the Schnell doctrine, a board’s action that affects a stockholder’s franchise rights, when taken in the face of a contested director election or stockholder vote touching on the issue of board control, is impermissible if the board was primarily motivated by personal or disloyal interests to thwart the stockholder’s vote. Under the Blasius doctrine, a disenfranchising action in this context, when taken by a board acting in good faith and with pure motivations (believing that the action was in the best interests of the corporation and its stockholders), is permissible only if there was a “compelling justification” for the action and the response was appropriately tailored to it.  Under the Unocal doctrine, when a board takes an action that has a defensive effect with respect to a takeover threat, the action is permissible only if it was reasonable and proportionate to the perceived threat and was not preclusive or coercive of the stockholder franchise. As noted, Delaware jurisprudence has long been evolving toward a combination of these doctrines.

The new, unitary standard. Under the new standard, in the context of a contested director election or stockholder vote touching on board control, if a board takes an action that interferes with a stockholder’s franchise, the board bears the burden of proving that: (i) there was a real, non-pretextual threat to an important corporate interest or to the achievement of a significant corporate benefit; (ii) the board had proper (not self-interested or disloyal) motivations; and (iii) the challenged action by the board was reasonable in relation to the threat posed, was tailored to only what was necessary to counter the threat, and did not deprive the stockholders of a vote nor coerce them to vote a particular way. In addition, with respect to (ii), the Supreme Court clarified that, under this standard, (a) a motivation is not proper that is based on the board’s belief that it knew better than the stockholders what was in the corporation’s and its stockholders’ best interests, and (b) the court can view a board’s motivations as having been proper even if there were some improper motivations alongside the primarily proper motivations.

The new standard reflects an evolution of Delaware jurisprudence toward relegating Schnell and Blasius to being specific applications of Unocal rather than being standards of review themselves. Delaware decisions have long recognized that Schnell, Blasius and Unocal are not mutually exclusive standards, as each recognizes the inherent conflicts of interest that arise when stockholders are not permitted free exercise of their right to vote. For many years, Delaware courts have referred variously to “incorporating” Blasius within Unocal; “infusing Unocal analyses with the spirit animating Blasius and Schnell”; or applying Unocal with “a gimlet eye out for,” or “greater sensitivity to” board action that has disenfranchising, preclusive or coercive effects.

A board action that interferes with stockholder franchise rights will be evaluated under the new standard even if the transaction was entirely fair. UIP makes clear that satisfaction of the entire fairness test is not the “end of the road” of the court’s analysis when reviewing a board action that was allegedly disenfranchising in the face of a contested director election or stockholder vote touching on board control. Even if a disenfranchising action is subject to and meets the entire fairness test (such as a dilutive stock issuance that was effected at a fair price after a fair process), the action will be evaluated also under the standard articulated in UIP.

It is still uncertain whether Blasius—and the new standard articulated in UIP—would apply to disenfranchising actions where the stockholder vote relates to topics other than a contested director election or board control. It has long been an open issue whether Blasius may apply in these other contexts. The Court of Chancery, in its 2003 Liquid Auto decision, stated that Delaware courts “have remained assiduous in carefully reviewing any board actions designed to interfere with or impede the effective exercise of corporate democracy by shareholders, especially in an election of directors”—which suggests that Blasius, and the new standard, could be applicable to any stockholder vote. While the Supreme Court quoted this sentence in the UIP opinion, the open issue was not addressed, as UIP involved a contested election and issues touching on board control.

The Supreme Court concluded that, in UIP, the dilutive Stock Sale satisfied the new standard. The Supreme Court found no error with the Court of Chancery’s finding, in its first decision, that the dilutive Stock Sale was a reasonable and proportionate response to a significant threat. (i) UIP had faced a significant threat—indeed, an “existential crisis to its existence”—through a deadlocked stockholder vote and the risk of a custodian appointment that would trigger termination rights by counterparties under many of the company’s key contracts. (ii) Although some of the board’s reasons for approving the Stock Sale may have been problematic, on balance the board was properly motivated in responding to the threat—specifically, it sought to break the 50-50 stockholder deadlock, moot the Custodian Action, and reward and retain an essential employee. (iii) The Stock Sale was a reasonable and proportionate response, “appropriately tailored to achieving the goal of mooting the Custodian Action while…retaining Bonnell,” and was not preclusive or coercive.

In concluding that the Stock Sale was not preclusive, the Supreme Court reasoned that, although the Stock Sale effectively foreclosed Coster from perpetuating the deadlock facing the company, the new three-way ownership of the company “presented a potentially more effective way for [Coster] to exercise actual control.” As Schwat and Bonnell were not bound to vote together, the Supreme Court stated, Coster could cast a swing vote at stockholder meetings, and, with this “realistic path to control” of UIP, the preclusive impact of the Stock Sale was negated. (Notably, the Supreme Court so concluded even though, arguably, it would appear that Bonnell and Schwat would have been more likely to continue to side with each other than either of them siding with Coster.)

The Supreme Court noted the following additional findings that the Court of Chancery made on remand, which supported the conclusion that the UIP board had not acted for selfish reasons: Coster had filed the Custodian Action without having made any meaningful effort to negotiate and resolve the election deadlock; Coster’s request for custodial relief was extremely broad—seeking a custodian empowered to exercise “full authority and control over the Company, its operations, and management,” rather than making a tailored request targeting the stockholder deadlock; UIP’s business model was dependent on the continued viability of the key contracts that contained the clauses with termination rights that could be triggered on the appointment of a custodian; and Coster was using the Custodian Action to create leverage to try to force a buyout of her equity interest by the company at a price detrimental to the company.

The Supreme Court rejected the plaintiff’s arguments that the dilutive Stock Sale should be invalidated on the grounds that it was unnecessary to achieve the company’s objectives. Coster had argued that the board could have advocated in the Custodian Action against appointment of a custodian rather than having diluted her equity. The Chancellor had found, and the Supreme Court agreed, that, under the unusual facts of this case, even the pendency of the Custodian Action caused the existential crisis for UIP—and the board was not required to risk court appointment of a custodian with broad powers that would trigger defaults under the company’s key contracts. Coster also had argued that the Stock Sale was unnecessary to retain Bonnell because he had not threatened to leave UIP if he did not receive the equity. The Chancellor rejected this argument as well, and the Supreme Court agreed, emphasizing that the Stock Sale fulfilled a prior equity commitment to Bonnell, that Bonnell was an employee who was “essential to the Company’s survival,” and that the Stock Sale encouraged Bonnell to stay with UIP.

The Court of Chancery and the Supreme Court emphasized that the facts and circumstances in this case were “exceptionally unique.” We note the following potentially distinguishing facts:

• The dilution was of a holder of 50%, under a 50-50 ownership framework, in the context of a deadlock on the election of directors—thus, the result could well be different if a board’s action dilutes a controlling position to less than control, or dilutes a less-than-50% stockholder to a lesser interest without the ability to cause a deadlock.
• The board’s action (i.e., issuing stock to an essential employee to whom equity had long been promised) effected a previously developed plan that had merit in and of itself, apart from the board control issues—thus, the result could well be different if a dilutive stock issuance is made to a non-employee, to an employee to whom equity had not long been promised, and/or to an employee who was less essential than Bonnell was to UIP.
• The Custodian Action (indeed, its very pendency) created an existential threat to the company’s existence, as counterparty termination rights could be triggered in key contracts that were essential to the company’s business plan—thus, the result presumably would be different if the contracts did not contain similar termination rights; the stockholder had sought a custodian with more limited powers, directed only at breaking the deadlock; and/or the contracts were not key contracts.
• Coster apparently brought the Custodian Action not because she believed it was in her best interest as a stockholder, but to create leverage in connection with her negotiations with the company to buy out her interest, and, further, she had declined the board’s generous buyout price and numerous compromise positions—thus, the result may be different where the board’s action thwarts stockholder action that the stockholder actually believes is in her best interest as a stockholder, and/or the overall equities otherwise weigh in the stockholder’s favor.

Practice Points

• A board must act equitably toward stockholders, with particular sensitivity where a board action would have an effect on a stockholder’s franchise rights. Boards should keep in mind, generally, that actions that are otherwise legally permissible, indeed even entirely fair, may be held to be inequitable if they unreasonably interfere with the stockholder franchise. Notwithstanding the precise applicable standard of review that may be applicable, a board should holistically evaluate its actions that may have a disenfranchising effect, to ensure equitable treatment of stockholders. The required analysis to determine whether a disenfranchising action is inequitable will be highly facts and circumstances dependent. A board should be scrupulous in maintaining a formal record (such as in board minutes) of the reasons that an action with a disenfranchising effect is in the best interests of the corporation and its stockholders.
• A company with a limited number of stockholders holding close to or more than a majority of the stock should have appropriate stockholder agreements in place. UIP was unusual in being such a company and not having a stockholder agreement with its two 50% stockholders. Stockholder agreements should address issues such as potential deadlocks, transfer restrictions, liquidity desires that may arise (such as on the stockholder’s death), veto or consent rights, and dispute resolution.
• When requesting relief from the court, it is generally advisable to tailor the request to seek only what is need to resolve the issue at hand. The result in UIP might well have been different, for example, if the plaintiff had sought appointment of a custodian with only those powers required to break the stockholder deadlock rather than broad powers to control the company generally.
• The Court of Chancery, as a court of equity, evaluates the totality of the facts and circumstances—and board attempts to act reasonably and resolve disputes tend to be viewed favorably by the court and may influence the court’s result. In UIP, the court noted that the UIP board responded to Coster’s difficult personal situation by discussing with her various possible exit scenarios under which she could obtain the liquidity she needed (and the deceased co-founder’s wishes for her financial security would be achieved), even though she had no legal rights entitling her to that. The court also noted Coster’s intransigence in her negotiations with the board, demanding a price that appeared to be severely inflated.