Fiduciary Duties of Controller Exercising Stockholder-Level Powers to Block Board Action

In re Sears Hometown and Outlet Stores Stockholder Litigation (Jan. 24, 2024), the Delaware Court of Chancery, in an important, post-trial opinion, for the first time clearly set forth the fiduciary duties and standard of review applicable when a controller uses its stockholder-level voting power to block action that the company’s board of directors has determined to be in the company’s best interest.

The court held that Eddie Lampert, the controller of Sears Hometown and Outlet Stores, Inc. (the “Company”), had fiduciary duties, albeit of a “limited” nature, when he acted by written consent to amend the Company’s bylaws and remove two directors (the “Controller Intervention”) in an effort to block a plan, adopted by an independent committee of the board (the “Committee”), to liquidate the company’s non-profitable business segment (“Hometown”) and continue its other, profitable segment (“Outlet”). The court, applying enhanced scrutiny review, found that Lampert had complied with his fiduciary duties.

The court also addressed a transaction (the “End-Stage Transaction”) that the Company negotiated with Lampert after the board became convinced that Lampert would block the liquidation plan and that it would not be sustainable for the Company to continue to operate with both business segments. The End-Stage Transaction involved a sale of the Company to Lampert, eliminating the minority stockholders’ interests (although Outlet was sold to a third party under the go-shop process in the merger agreement). As Lampert was self-interested in the End-Stage Transaction, the standard of review was entire fairness. The court found that Lampert “sincerely believed” that the transaction was fair, but the transaction did not satisfy entire fairness. The court ordered Lampert to pay damages (over $18.3 million) to the minority stockholders. On January 31, 2024, Lampert’s counsel filed a motion for reargument with respect to the End-Stage Transaction, arguing that correction of an alleged error in the court’s valuation analysis should lead to the conclusion that the price fell within the range of reasonableness or at least would result in a substantial decrease in the damages awarded by the court.

In this Briefing, we discuss the court’s controller fiduciary duty analysis relating to Lampert’s Controller Intervention to block the board’s plan to liquidate Hometown; and we offer related Practice Points.

Key Points

• The court, for the first time, clearly established that controllers have certain “limited” fiduciary duties when exercising their stockholder voting power to “alter the status quo.”  Controllers have duties of good faith and due care that demand that they not harm the corporation or its minority stockholders intentionally or through grossly negligent action. The court clarified that controllers do not have the higher-level duty that directors have to act affirmatively to promote what they believe is in the best interests of the corporation.

• The court also held, for the first time, that “enhanced scrutiny” review will apply to controllers’ conduct in this setting.  Enhanced scrutiny—Delaware’s intermediate standard of review—will apply, the court held, when controllers may have “subtle” conflicts and took action in areas traditionally reserved for the board of directors. Under this standard, controllers bear the burden of proving that they acted in good faith, after a reasonable investigation, to achieve a legitimate objective, and that they used reasonable means to achieve the objective.

• The decision thus confirms that controllers can intervene to block the board from pursuing its chosen course of action—subject to limited fiduciary duties when the controllers are affirmatively exercising their voting power “to change the status quo.” The court expressly rejected the plaintiffs’ argument that such an intervention is inherently inequitable and constitutes a breach of duty because it trespasses on the board’s right to manage the affairs of the corporation. Based on this decision, it appears that, when controllers amend bylaws or remove directors (i.e., change the company’s governance) to block the board’s chosen course of action, the court will view the controllers as using their voting power to affirmatively change the status quo—even if they blocked the board action in order to preserve the company’s operational status quo.

• The court found that Lampert acted properly when engaging in the Controller Intervention. The court held that, as Lampert affirmatively exercised his voting power to change the status quo, he was subject to limited fiduciary duties; and, under enhanced scrutiny review, he satisfied those duties. He acted in good faith, with the legitimate objective of blocking what he believed, after a reasonable investigation, to be a value-destroying plan; and he used reasonable means, as the bylaw amendment and director removals, while “drastic,” were “necessary” to achieve his objective given that the board could not be convinced to drop its plan and was moving unilaterally to implement it.

• We note that duties not to harm intentionally or through gross negligence should not present a significant obstacle to controller action. While the court applied fiduciary duties to controllers when exercising their stockholder-level voting power to change the company’s status quo, as noted, the fiduciary duties are far more limited than those that apply to directors. The court observed that, while some controller interventions involve a “‘bad guy’ seeking with guile to protect or advance private interests,” others simply involve a board and a controller having “differing, but plausible, conceptions of what constitutes right action in the circumstances.”

Background. The Company, originally a subsidiary of Sears Holding Corporation (“Holdings”), was spun off from Holdings in 2012 and became a separate, publicly traded entity. In the spin-off, the complex of investment funds controlled by Lampert, which held a majority of Holdings’ common stock, received a majority of the Company’s common stock. Over the seven-year period of Lampert’s investment in the Company prior to the events giving rise to this case, he had been a largely supportive and passive investor, notwithstanding that the share price had declined from a high of $55.62 per share to just $2.30 per share (equating to a $600 million loss for Lampert’s funds). Neither Lampert nor any of his affiliates or close associates sat on the Company’s board of directors (the “Board”).

The Company operated through two separate business segments—Homeland, which represented about two-thirds of the Company’s assets and revenues and had been unprofitable for years (a “bad business” in the Board’s view); and Outlet, which had become profitable in the most recent year after several years of being unprofitable (a “good business” in the Board’s view). The Committee endorsed a plan to liquidate Homeland and then continue to operate Outlet. Lampert believed, and tried to convince the board, that this plan would be value-destructive. The board disagreed. To avoid the board implementing the liquidation unilaterally, Lampert offered to buy the Company for $2.25 per share. The board rejected the offer, and ultimately countered with an ask of $9.50 per share, which Lampert viewed as totally unrealistic. Lampert then effected the Controller Intervention. The Board—convinced that Lampert would block the liquidation plan, and convinced that it was not sustainable for the Company to continue the status quo of operating both business segments—negotiated with Lampert for the End-Stage Transaction, which provided the Company’s stockholders with $3.21 per share, representing a premium of 76% over the price of the Company’s stock before Lampert’s $2.25 Offer.

Minority stockholders brought suit, claiming that Lampert had breached his fiduciary duties by using his stockholder voting power to block the liquidation plan. In a 120-page opinion, Vice Chancellor J. Travis Laster held that Lampert had fiduciary duties when using his stockholder voting power to block the liquidation plan, but had fulfilled them. The court held, further, that the End-Stage Transaction, in which Lampert was self-interested, was not entirely fair to the minority stockholders. The court ordered Lampert to pay damages of $1.78 per share (totaling $18.3 million), plus interest. As noted, a motion for reargument has been filed by Lampert’s counsel seeking correction of an alleged error in the court’s valuation analysis—which could result in the court reaching a different entire fairness conclusion or substantially reducing the damages payable.

Discussion

Context in which controller action invokes fiduciary duties. The court explained that there are two contexts in which a controller’s actions implicate fiduciary duties. One context (the more familiar of the two) is when the controller “use[s] its influence over the board and management to wield corporate power indirectly and cause the corporation to act.” In this scenario, the controller “effectively move[s] into the boardroom,” and so becomes subject to the same fiduciary standards that apply to directors. The other context is when, as in this case with respect to the Controller Intervention, the controller directly exercises his voting powers as a stockholder to affect board action. In this second context, the court observed, there are “competing strains of authority” as to whether the controller has fiduciary duties. Some Delaware decisions, the court stated, have asserted that a controller can exercise stockholder-level rights free of fiduciary constraint, just as non-controlling stockholders can. Other decisions, however, have asserted that fiduciary duties do apply when a controller exercises stockholder-level rights—“because the controller’s ability to act solely in its own interest as a stockholder must yield…when a corporate decision implicates a controller’s duty of loyalty as well”—but in these decisions the court has not well defined the duties.

Fiduciary duties when a controller exercises stockholder-level voting power. The court reasoned that Delaware precedent relating to a controller’s decisions with respect to selling his shares should also apply to a controller’s decisions relating to voting his shares. The precedent indicates that a controller does not owe fiduciary duties when deciding not to sell his shares; but owes fiduciary duties when deciding to sell his shares, although these duties are “limited”—for example, a controller cannot knowingly or recklessly sell his shares to a looter. Similarly, in the context of voting shares, the court concluded, a controller would not owe fiduciary duties when deciding not to vote his shares or when voting against a change to the status quo, but would owe limited fiduciary duties when affirmatively voting to change the status quo. These “limited” fiduciary duties are: “a duty of good faith that demands the controller not harm the corporation or its minority stockholders intentionally[; and]…a duty of care that demands the controller not harm the corporation or its minority stockholders through grossly negligent action.” The court noted: “Directors, by contrast, must act affirmatively to promote the best interests of the corporation, and they must subjectively believe that the actions they take serve that end. A controller need not meet that higher standard when exercising stockholder-level voting rights.”

Applicability of enhanced scrutiny review to evaluate whether a controller breached his fiduciary duties. The court observed that the Delaware courts have not established a standard of review when evaluating whether a controller breached his fiduciary duties when in connection with a sale or the voting of his control block. The court concluded that “enhanced scrutiny”—which lies between the extremes of the business judgment rule and the entire fairness standard—is the appropriate standard when a controller (i) faced a “subtle conflict” (i.e., not a conflict so stark, such as a self-interested transaction, that it gives rise to entire fairness review), and also (ii) took action that “invaded the space traditionally reserved for the board of directors.” The court reasoned that enhanced scrutiny applies to evaluate directors’ conduct when directors face subtle conflicts and act in areas traditionally reserved to the stockholders (such as issues touching on corporate control), and the same standard should apply when “the shoe is on the other foot,” with a stockholder facing subtle conflicts and acting in areas traditionally reserved to the board. In this case, “while the actions [Lampert] took affected all stockholders equally, he had business agreements with the corporation [(certain related-party agreements with Holdings entered into at the time of the spin-off)] that could have skewed his judgment”—although they tended to favor the Company rather than Holdings; and he acted in an area traditionally in the board’s province (a decision whether to liquidate a business).

Lampert’s concerns about the liquidation plan. Lampert believed that the board’s plan to liquidate Hometown and continue to operate Outlet would be value-destroying. He believed that the Committee was: (i) overestimating the proceeds that the liquidation could generate—as the liquidation would involve over 500 stores being liquidated over just eight weeks (while the Company’s valuation was based on the Company’s prior liquidations that had involved no more than 20-30 stores at a time and had taken place over a period of years); (ii) underestimating the liabilities that would arise as a result of the liquidation—as it would cause the stores’ dealer agreements to be breached; and (iii) overestimating the performance of Outlet going forward—as it had just become successful after years of unprofitability, would not have the necessary scale as a standalone entity, and would have to assume all of the liabilities arising from the liquidation. Lampert’s concerns intensified after he found no detailed analyses in the Company’s data room with respect to these critical issues.

Lampert’s intervention to block the board’s plan. Lampert acted by written consent to amend the bylaws and remove two directors. Bylaw Amendment: The bylaw amendment required that a Hometown liquidation receive approval from 90% of the Board, at two separate Board votes taken at least thirty business days apart. If the liquidation received the necessary vote at the first meeting, the Board would be required to disclose the result to the stockholders. The amendment thus did not prevent the Board from pursuing the Hometown liquidation, but, as a practical matter, it created a window during which Lampert could take additional action before the second meeting to stop the liquidation. Lampert acknowledged at trial that he intended to not let the liquidation go through. Director Removal: Lampert removed the two directors who, when he had met with the Committee, were the most vocal supporters of the liquidation. He filled the resulting vacancies with two individuals whom he did not know personally but had been suggested to him by a friend who was a managing partner at a private equity firm. The court commented that “Lampert could be confident that [they] would support his interests, even without any direct ties between them.” Lampert sent a letter to stockholders announcing the bylaw amendment and removal of directors, and explaining his strong disagreement with the board’s liquidation plan.

Lampert met the enhanced scrutiny standard. Under enhanced scrutiny, the fiduciary bears the burden of proving, first, that he “acted in good faith, after a reasonable investigation, to achieve a legitimate objective,” and, second, that he “adopted a reasonable means of achieving that end.” The court found that Lampert met this burden. He established that he:

• Had a legitimate objective—namely, promoting the long-term value of the corporation by preventing the destruction of value that he believed the Hometown liquidation would cause.
• Acted in good faith—his testimony was credible that (and his contemporaneous communications also reflected that) he had engaged in the Controller Intervention because he believed that the board would implement the Hometown liquidation unilaterally and that the liquidation would destroy value and harm the Company and its stockholders.
• Had a reasonable basis for his beliefs—he did not have “a detailed slide deck or report documenting his beliefs,” but “[his] testimony [was] enough,” as the testimony was credible; he “had invested in retail for decades”; “had lived through bankruptcies” of other companies; and “was generally familiar with the risks that retail liquidations pose, particularly when conducted outside of bankruptcy.”
• Used reasonable means to achieve his objective—the bylaw amendment and removal of directors were “drastic but necessary,” and Lampert “only engaged in them after concluding that he had no viable alternative.” He had made numerous, but unsuccessful, efforts to persuade the Committee, the board, and management that the liquidation would destroy value, and to negotiate an alternative path (such as his buying Hometown, Hometown’s inventory, or the Company); and the Committee had informed him that it would be implementing the liquidation plan without a stockholder vote.

Observations with respect to controller fiduciary duties:

• Lampert’s true objective. We note that, if the court had viewed the End-Stage Transaction, or some other self-interested transaction, as Lampert’s real (or ultimate) objective, it likely would not have concluded that he had complied with his fiduciary duties. The court emphasized that it was the Committee that ultimately wanted Lampert to acquire the Company, while Lampert’s true objective all along was simply to block the liquidation plan that he believed was value-destroying.
• Lampert’s “correct” analysis. Query to what extent the court’s result was influenced by its view (which it expressly stated) that Lampert was “correct” that the liquidation plan would be value-destroying. Certainly, a “correct” view is not required for a finding of compliance with fiduciary duties, but the court’s view of the correctness (or lack thereof) of a controller’s decision may influence the judicial result.
• Distinguishing features. Potentially distinguishing features of this case include that: Lampert had such a high level of expertise and experience (including specifically with liquidations); the Committee had apparently ignored some important “real-world implications” of the liquidation plan; Lampert had been a largely passive investor in the Company (and, indeed, all the public companies in which he was invested) and had never before acted by written consent to amend bylaws or remove directors; and, as the court noted, Lampert “took action that was less drastic than he might have taken,” as the bylaw amendment did not prevent the liquidation plan, he removed only two directors, and he did not fill the board vacancies with himself or individuals he controlled.

Practice Points

• A controller must be mindful that, under certain circumstances, it will have (albeit limited) fiduciary duties when exercising its stockholder-level powers. Based on Sears Hometown:
  • A controller has no fiduciary duties to the corporation and its minority stockholders when (i) deciding not to sell its shares, (ii) deciding not to vote its shares, (iii) acting to prevent dilution by the board of its control position, or (iv) voting its shares against “a transaction that would alter the status quo.”
  • A controller likely has limited fiduciary duties (not to harm the corporation or its minority stockholders intentionally or through gross negligence) when (i) deciding to sell its shares, or (ii) “exercising its voting power affirmatively to change the status quo.”
  • The decision seems to indicate that the court would view a controller’s amending the bylaws or removing directors as exercising voting power affirmatively to change the status quo—even if the controller is seeking to preserve the company’s operational status quo by blocking a board plan that would change the status quo.

• A controller seeking to block a board plan should consider taking actions that do not fully block the plan. In Sears Hometown, the court viewed it as a factor in the controller’s favor that the bylaw amendment did not block the liquidation plan (although it provided the controller with another opportunity to block it); and that only two directors were removed and they were replaced with individuals not closely associated (although the court viewed them as likely to support the controller’s interests).

• A controller should not be reckless when deciding to vote his shares to block board action. In Sears Hometown, although the controller had not prepared detailed analyses supporting his view, he had engaged in discussions with Committee, management and the board; he understood the board’s plan; and he had sufficient information (including, from his own experience, “about the perils of retail store liquidations” especially in a non-bankruptcy context) to make an assessment that was not grossly negligent.

• Where a controller takes a series of actions, different levels of fiduciary duties may apply. If, for example, a controller seeks to block a board plan and also seeks to buy the company, limited fiduciary duties may apply to intervening with the board plan, while buying the company would be subject to entire fairness. In this situation, a controller should maintain a record that reflects that his objective to block the board plan is motivated by his views about the plan and not by a desire to acquire the company.