Cloudflare: Controllers Unbound, as Long as an Adequate Paper Trail is Kept

In a recent study, Controllers Unbound, Kobi Kastiel and I explain how the relaxation of control constraints following the adoption of SB21 should be expected to have substantial adverse effects on public investors and controlled companies. Among the risks that we identified were those resulting from enabling controllers to pursue recapitalizations using nonvoting shares to retain a lock on control while cashing out a substantial fraction of the controller’s equity stake. The recent Cloudflare decision (discussed in the Forum here) focused on such a recapitalization. Although the decision allowed the dismiss shareholder suit challenging the recapitalization to proceed to trial, it nonetheless validates and reinforces the concerns we raised in Controllers Unbound.

Delaware’s recent SB21 legislation provided controllers with a safe harbor for conflicted transactions (other than freezeouts) that satisfy certain process requirements. Under SB21 cleansing such transactions generally would not require approval by public investors; controllers would just need to obtain approval from two independent directors that are willing to go along. As a result, our study explained, post-SB21, controllers would have an array of ways to benefit themselves considerably at the expense of public investors – including by control-perpetuating recapitalizations, elimination of long-standing sunsets, large related-party transactions, extraction of mega-pay packages, and so forth and so on.

Some observers have nevertheless retained hope after the adoption of SB21 that Delaware courts would in many cases find ways to protect public investors from being harmed by conflicted transactions. Cloudflare should greatly curtail any such hopes.

In Cloudflare, the shareholder suit sought to use some language in SB21 to argue that SB21’s safe harbor does not cover conflicted transactions that are control-enhancing. The case was assigned to Vice Chancellor Travis Laster, who in pre-SB21 days contributed to a line of cases that SB21 reversed. However, Laster concluded that SB21 compelled him to reject the claimed exception to the statute.

To be sure, VC Laster still ordered a trial. But he did so only to examine whether the company complied with the procedural requirements of SB21, and he explicitly based this decision on rather extraordinary circumstances that well-lawyered controllers should be expected to avoid in the future.

In a client memorandum (posted on the HLS Forum here), the law firm of Wachtell Lipton stressed that Laster’s Cloudflare decision:

• “reinforce[d] Section 144 protections;”
• “resolved every statutory question concerning the scope and application of Section 144 in favor of the defendants, affirming that the statute provides ‘powerful protection for conflicted transactions’;”
• “shut down a host of plaintiff side challenges that sought to rob Section 144 of its intended import;” and established that
• the exception in the SB21 language is limited to the narrow categories of “defensive measures that would trigger enhanced scrutiny” and should not be extended to conflicted transactions such as recapitalizations that SB21 sought “to protect against entire fairness review.”

The memo also observes that, as I noted above, the decision to hold a trial in this case was only due to exceptional circumstances:

“The injunction grant turned on an unusual record that enabled the stockholder plaintiffs to assert that coercive and aggressive behavior of the controlling founders, together with evidence of process issues that included unauthorized backchannel communications and deleted Signal messages, impacted the special committee’s fulfillment of its fiduciary duties.”

and

“[the] conclusion turned on an extraordinary but preliminary record of unauthorized communications with the controllers, including threats, profanities, and coercive statements by one of the founders; disappearing Signal messages and directors’ deposition testimony that was contradicted by surviving electronic communications; and the company’s announced plan to close the transaction despite a prior commitment to await the Court’s ruling.”

The above alarming aspects of the record are ones that well-lawyered controllers would generally be able to avoid in the future. The Wachtell memo appears to share this view, stating that – “[w]e will address in a subsequent memorandum the broader implications of this case for how boards document important transactions and use information technology.”

In conclusion, Cloudflare thus reinforces the concerns expressed and detailed in Controllers Unbound. Institutional investors, and all those concerned about the protection of public investors, should pay close attention to these concerns.