Chancery Decision Heightens Litigation Risk Associated with Reincorporation from Delaware

In Palkon v. Maffei (“TripAdvisor”) (Feb. 20, 2024), the Delaware Court of Chancery held that the reincorporation of TripAdvisor, Inc. (a controlled company) from Delaware to Nevada is subject to the entire fairness standard of judicial review. The court found, at the pleading stage of litigation, that it was reasonably conceivable (the standard for non-dismissal of claims at that stage) that the reincorporation was not entirely fair to the minority stockholders. The court reasoned that the reincorporation may have deprived the minority stockholders of “litigation rights” that they had under Delaware law but would not have under Nevada law given Nevada’s allegedly lower standards for fiduciary duties of directors and controlling stockholders. While the court did not grant the plaintiffs’ request for an injunction, it rejected the defendants’ motion to dismiss claims that the directors had breached their fiduciary duties by approving the reincorporation. Therefore, the reincorporation can close, but the plaintiffs can proceed to seek monetary damages for the reduction in the minority stockholders’ rights under Nevada law.

Key Points

• The decision heightens the litigation risk associated with reincorporation of a controlled Delaware corporation to Nevada. The court applied the entire fairness standard of review as, at the pleading stage, it viewed the reincorporation as a transaction effectuated by self-interested fiduciaries (i.e., the directors and controlling stockholder) who received a non-ratable benefit (i.e., lower potential liability, due to Nevada’s allegedly lower fiduciary standards) at the expense of the minority stockholders (i.e., a reduced ability under Nevada law to bring fiduciary claims).
• The decision may be distinguishable on the basis that the board in this case, apparently, emphasized obtaining protection from liability for its directors, officers and controller as the key reason for the reincorporation. The court viewed the other benefits of reincorporation that the defendants cited (such as lower franchise taxes) as likely being “immaterial.” An important question—which the court did not address—is whether a different result would obtain where a company establishes that its primary motivation, or that a substantial part of its motivation, is to obtain ratable benefits that would inure to the company as a whole, even though the reincorporation also would provide a non-ratable benefit to the company’s fiduciaries. Such ratable benefits might include, say, the benefit of a reduction in potential liability of the corporation for mass tort suits, or the benefit of a constituency statute that aligns with the company’s values.
• The decision raises new considerations for a controlled company structuring a reincorporation from Delaware. The decision confirms that a reincorporation would be subject to deferential business judgment review (rather than entire fairness) if conditioned on the dual MFW prerequisites (i.e., approval by a special committee of independent directors and by a majority-of-the-minority stockholders). The decision also suggests that, where entire fairness applies, that standard would more likely be satisfied if adequate “compensation” is provided to the minority stockholders for the reduction in their litigation rights. We note, however, as discussed below, uncertainty with respect to the feasibility of satisfying the MFW conditions in this context. Also, as discussed below, it is unclear what compensation to the minority stockholders would be adequate.
• The decision highlights recent increased interest in reincorporation by controlled Delaware corporations—although such moves remain rare. The interest has been prompted by a few high-profile Delaware decisions in recent months that have held in favor of plaintiffs’ claims against controlling stockholders and directors of controlled companies. Highly publicized remarks have been made by Elon Musk urging companies to move from Delaware. A small number of controlled companies have moved from Delaware (including Musk’s Neuralink Corp. and SpaceX Inc., which this month reincorporated to Nevada and Texas, respectively). Nevada in particular has made a strong effort over the past several years to develop its corporate fiduciary law as part of an effort to encourage companies to incorporate there. It remains to be seen whether other controlled corporations will choose to forego Delaware’s well-established corporate law and the special expertise of its Court of Chancery.
• We do not expect that non-controlled Delaware corporations will seek to reincorporate. We note that directors of non-controlled companies face fewer litigation challenges; business judgment review generally will apply to actions taken by boards of non-controlled companies (so long as stockholder approval is obtained through a fully informed vote); and, without a controlling stockholder, stockholder approval in most circumstances would be unlikely.

Background

TripAdvisor, Inc. (“TripAdvisor”) and Liberty TripAdvisor Holdings, Inc. (“Holdings”) were public corporations incorporated in Delaware. Through dual-class voting structures at both companies, Gregory B. Maffei—who was the CEO and Chair of Holdings, and also a director of TripAdvisor—had majority voting control over both companies (while owning 21% of the equity interest in TripAdvisor). In late 2022, TripAdvisor management proposed to the board the possibility of converting TripAdvisor into a Nevada corporation. After further discussion at meetings in March and April 2023, the boards of Holdings and TripAdvisor, respectively, approved the reincorporation. At stockholder meetings in June 2023, the stockholders of Holdings and TripAdvisor, respectively, approved the reincorporation. Maffei’s shares were decisive, with only a small percentage of shares held by unaffiliated stockholders voting in favor.

In April 2023, the plaintiff-stockholders brought suit against Maffei and the other directors, claiming that they had breached their fiduciary duties by approving the reincorporation, and seeking an injunction to prevent closing of the reincorporation. (On February 9, 2024, TripAdvisor announced that it had entered into discussions with Holdings about a going-private transaction that would be subject to the MFW protections. The parties to the lawsuit agreed that the potential for a going-private transaction at some point in the future should not affect the pending litigation, and both sides asked the court to render a decision.) The court, in a pleading-stage decision issued by Vice Chancellor J. Travis Laster, held that entire fairness review applies, and that the recapitalization may not have been entirely fair. The Vice Chancellor rejected the defendants’ motion for dismissal, but declined to issue an injunction.

Discussion

The court viewed the reincorporation as a self-interested transaction providing a non-ratable benefit to the controller and the directors. The court emphasized that, given Nevada’s allegedly lower fiduciary standards as compared to Delaware’s, the reincorporation would effectuate greater protection from liability for the controller and the directors, with a corresponding “reduction in the unaffiliated stockholders’ litigation rights.” Accordingly, as the transaction was not structured to include any “protective devices [(such as under MFW)] that could lower the standard of review,” the entire fairness standard of review (Delaware’s “most onerous standard”) applied. The court stressed that, as a policy matter, “[f]rom the perspective of equity, Delaware law should be just as concerned about transactions that reduce stockholders’ litigation rights as it is about transactions that reduce their economic rights or governance rights,” because “economic rights and governance rights remain meaningful only to the extent that litigation rights back them up.”

The record reflected that the board sought the reincorporation to obtain “greater protection against liability” for the controller, the directors and the officers, through Nevada’s lower fiduciary standards. The management’s presentations to the board, the board minutes and the proxy statement all emphasized this purpose and the corresponding reduction in the risk of “expensive and time consuming litigation.” Specifically, the board considered that: (i) under Nevada law, a director or officer can be liable only for intentional misconduct, fraud or a knowing violation of law—while in Delaware there is liability for gross negligence and duty of loyalty violations; (ii) under Nevada law, the business judgment rule presumptively applies even to transactions in which a controller or the board is self-interested—while in Delaware entire fairness applies to such transactions unless the MFW procedural protections are in place; and (iii) under Nevada law, in a sale-of-the-company context, there are no Revlon duties and there is a constituency statute (permitting consideration of the interests of non-stockholders)—while in Delaware a board must seek to obtain for stockholders the highest price reasonably available. The board also considered that in recent years numerous lawsuits had been brought in Delaware against companies affiliated with Maffei; and that recent Delaware court decisions “have increasingly emboldened plaintiffs” to bring claims in Delaware against directors, officers, and significant stockholders of controlled companies.

The court viewed other alleged benefits of the reincorporation as likely to be immaterial. The court held that the reduction in liability exposure for the company’s fiduciaries, without procedural protections for the minority stockholders, supported a reasonable inference of unfairness. The defendants argued that other benefits from the reincorporation rendered it fair—such as the lower franchise taxes and a greater ability to recruit directors and management personnel due to the reduced liability exposure. The court stated that it could not assess at the pleading stage whether these other benefits rendered the reincorporation fair—but its commentary suggests that it would not view them as rendering the reincorporation fair. The reduction in franchise taxes “appear[ed] immaterial given the size of the Company and Holdings,” and the greater ability to recruit personnel “seem[ed] to be a function of reduced litigation exposure, so it [was] not really a separate benefit,” the court stated.

The court found the plaintiff’s allegations supported a reasonable inference that the reincorporation was not entirely fair. To satisfy the entire fairness standard, defendants bear the burden of proving that the challenged transaction was both substantively and procedurally fair. (The burden shifts to the plaintiffs to prove unfairness of the transaction if it was approved either by a special committee of independent directors or by the minority stockholders in a fully informed and non-coerced vote—neither of which occurred here.)

With respect to “substantive fairness”—often referred to as the “fair price” prong of the entire fairness test—the court stated that “[t]he floor…is whether stockholders receive at least the substantial equivalent in value of what they had before.” In this case, the court wrote: “Before the conversion, the stockholders held shares carrying the bundle of rights afforded by Delaware law, including a set of litigation rights. After the conversion, the stockholders owned shares carrying a different bundle of rights afforded by Nevada law, including a lesser set of litigation rights. That makes it reasonably conceivable that the stockholders do not possess at least the substantial equivalent of what they possessed before, supporting an inference that the conversion was not substantively fair.”

With respect to “procedural fairness”—often referred to as the “fair process” prong of the entire fairness test)—the court stated that “[t]he test…is whether the process leading to the conversion adequately simulated arm’s length bargaining.” The court wrote that in this case: “As depicted, the stockholder controller and the board did not implement any procedural protections. The board recommended the conversion, and the stockholder controller delivered the vote. Those allegations support an inference that the conversion was not procedurally fair.”

The court did not decide whether Nevada law actually provides greater protection against fiduciary liability than Delaware law—but suggested that it likely does. At the pleading stage, the only question was whether, accepting the plaintiffs’ allegations as true and making all reasonable inferences in their favor (as required at the pleading stage), it was reasonably conceivable that Nevada law offers greater protection against fiduciary liability. The court stated that the facts alleged by the plaintiffs “suggest[ed] that [Nevada law] does [offer greater protection], that the defendants think so too, and that the defendants sought to capture those benefits for themselves through the [reincorporation].”

The court declined to issue an injunction—and stated that monetary damages would be an adequate remedy. First, the court rejected the defendants’ contention that “a Delaware court cannot enjoin an entity from leaving the state.” The court stated that, “[i]n extreme scenarios,” the court “in theory…could enjoin the company from departing Delaware if the equities warranted it.” In this case, the court wrote, such an “extreme result” was inappropriate as the court “quite likely…can craft a monetary remedy…that would be adequate” to compensate the minority stockholders from “the harm, if any, that moving from Delaware to Nevada imposes on the[m].” The court suggested that stock price reaction to the move could “help quantify the harm,” so long as the market for the company’s stock is semi-strong-form efficient. The court noted scholarly literature indicating that stockholders face difficulty in pricing governance structures—but, the court commented, these observations generally relate to a corporation’s IPO phase, during which there are many unknowns and investors’ focus is on highly uncertain potential future economic performance of the company. By contrast, stock price change may be more indicative of the impact of a reincorporation, as “nothing will change except the [c]ompany’s corporate domicile.”

The court commented that the decision does not discriminate against Nevada nor prevent corporations from leaving Delaware. First, the court stated, the decision “does not discriminate against Nevada entities,” as “[t]he same reasoning would apply if a Delaware corporation converted into another Delaware entity in a transaction with comparable implications”—for example, if a Delaware corporation converted to a Delaware LLC that eliminated all fiduciary duties, or to a Delaware LLC that was crafted to mirror the internal governance structure of a Nevada corporation. Second, the court stated, the decision does not mean “that a corporation can never leave Delaware.” The court pointed out that it was not granting an injunction barring TripAdvisor’s reincorporation. Third, the court stated, the decision does not mean “that a corporation can never leave Delaware without litigation risk.” For example, the court stated, there may have been no valid claim in this case (i) if there had not been a stockholder controller and there had been full disclosure to the stockholders of the consequences of the change in legal regimes (in which case Corwin business judgment deference would have applied); or (ii) even with a stockholder controller, if the reincorporation had been conditioned on the dual MFW prerequisites (in which case business judgment deference would have applied), or the defendants had “compensate[d] the stockholders for the reduction in their litigation rights” (in which case the entire fairness standard may have been satisfied).

We note a trend of 2024 Court of Chancery decisions against controllers. In addition to TripAdvisor, the court has issued the following in the first two months of this year:

• West Palm Beach Firefighters’ Pension Fund v. Moelis & Company (Feb. 23, 2024)—which invalidated a controller’s extensive veto and other rights set forth in a stockholders’ agreement with the corporation, on the basis that in combination they violated DGCL Section 141(a)’s mandate that the affairs of a corporation be managed and directed by its board of directors (we will be issuing a Briefing on this seminal decision shortly);
• Tornetta v. Musk (Jan. 30, 2024)—which invalidated Elon Musk’s $58 billion equity-based ten-year compensation plan (see our Briefing here); and
• Sears Hometown and Outlet (Jan. 24, 2024)—which established that controllers have certain (albeit limited) fiduciary duties when voting their shares to block board action (see our Briefing here).

Practice Points

A controlled company considering a reincorporation should:

• Conduct a careful cost-benefit analysis. The analysis should include all factors potentially benefitting or disadvantaging the corporation and its directors, officers, controllers and the stockholders generally. The board should consider the possible impact on the corporation’s stock price and cost of capital of moving to a less certain corporate legal regime and courts with less expertise in corporate matters. The board should maintain a record of its considerations, possibly including its weighting of the various factors.
• Consider carefully the differences in fiduciary standards in the new state and their impact on “stockholder litigation rights.” Legal counsel should advise the board of the impact of the different fiduciary standards in the new state on specific possible future transactions and issues (such as going private transactions, transactions with the controller, executive compensation, and Caremark claims, among others). Special attention should be given to providing adequate disclosure in the proxy statement of the effects of the reincorporation on stockholder litigation rights. We note that Nevada has a more developed body of law on fiduciary standards than most other non-Delaware jurisdictions—thus the analysis may be more nuanced and less clear when reincorporation is to a different state (such as Texas, which has a less developed body of law than Nevada and affords a less straightforward comparison with Delaware’s law).
• Seek to identify and emphasize material benefits that would benefit the company as a whole. As discussed, although the court suggested that the other, ratable benefits identified by the defendants in TripAdvisor (namely, lower franchise taxes and a greater ability to recruit directors and managers) likely would be immaterial, other kinds of ratable benefits—alone or in combination—potentially could be viewed as material and thus render a reincorporation entirely fair notwithstanding some greater protection from liability for company fiduciaries. Such ratable benefits might include, for example, obtaining greater protection, for all the stockholders, against the corporation’s exposure to liability in mass tort lawsuits; or obtaining better alignment with the corporation’s values and priorities through reincorporation to a state having a constituency statute or a particular political culture.
• Consider including the MFW protections. As discussed, while the court indicated MFW as a route to business judgment review of a reincorporation, it is unclear to us whether the independent-director approval prong of MFW could be satisfied given the court’s view in TripAdvisor that the directors were inherently self-interested based on the reduced liability exposure they would obtain through the reincorporation. We surmise that the court might view directors as independent when, unlike in TripAdvisor, the reincorporation is to a state where the fiduciary standards are not necessarily materially lower than Delaware’s; and/or when the directors have emphasized ratable benefits as the primary (or a substantial) motivation for the reincorporation. We note also that it may not be feasible as a practical matter to satisfy the minority-stockholder approval prong of MFW, as (at least absent a “sweetener”) minority stockholders may be unlikely to approve a move from Delaware that could result in a reduction in protections for them.
• Consider compensating the minority stockholders for any reduction in their litigation rights (and/or other disadvantages associated with the reincorporation). The court suggested in TripAdvisor that stock price impact on announcement of a reincorporation could provide a helpful guide to what amount of compensation would be adequate. The reliability of stock price impact obviously is reduced to the extent that other company changes may be expected or the stock price or the market generally is volatile.
• Consider crafting a bespoke set of governance rights. To enhance the likelihood of minority stockholder approval and judicial acceptance of a reincorporation, the board could carve out specific transactions or issues from the lesser fiduciary standards applicable in the new state. For example, the reincorporation could be structured so that, say, going private transactions and other conflicted-controller transactions would continue to be governed under Delaware law or would be permissible only if MFW conditions were satisfied; while, say, Caremark claims, executive compensation for a controller (possibly only if not meeting pre-established guidelines), and/or other specified claims or actions would be governed under the laws of the new state.

Incorporation outside Delaware should be considered at the IPO stage. Given the increased focus on reincorporation, and difficulties after TripAdvisor associated with reincorporation, there should be special attention given at the IPO stage to the state of incorporation, rather than relying on reincorporating later.