Controlling Stockholder Exercising Voting Power as Stockholder to "Change the Status Quo" Owes Fiduciary Duties
In Short
The Background: After unsuccessfully trying to convince the special committee not to implement a plan to liquidate a business line, which the controlling stockholder believed would destroy value, the controlling stockholder used its voting power to: (i) adopt a bylaw amendment imposing procedural requirements on the committee's liquidation plan that did not technically foreclose the plan and (ii) remove two board members (which also removed them from the committee) and fill the board vacancies with new appointees. Subsequently, the controlling stockholder negotiated a transaction to acquire the company with the remaining committee member.
The Result: The court found that the controlling stockholder acted reasonably and in good faith and did not breach its fiduciary duties by exercising its voting power to adopt the bylaw amendment and remove/replace board members. However, the court found that the controlling stockholder breached its fiduciary duties in connection with the negotiated transaction based on the price paid and the process under the entire fairness standard.
Looking Ahead: Controlling stockholders should be aware that they can refuse to sell their shares, vote against a transaction, or decline to vote at all without implicating their fiduciary duties to the corporation or the minority. However, when exercising voting power affirmatively to change the status quo, they must show that they acted in good faith for a legitimate objective and had a reasonable basis for believing that action was necessary and that they selected a reasonable means for achieving their legitimate objective.
On January 24, 2024, the Delaware Court of Chancery issued a post-trial decision in In re Sears Hometown and Outlet Stores, Inc. Stockholder Litigation. The principal defendant was the majority stockholder of Sears Hometown and Outlet Stores, Inc. ("SHO"). SHO operated via two business units, Sears Hometown and Hardware ("Hometown") and Sears Outlet ("Outlet"), both of which performed poorly following SHO's spin-off from Sears Holdings Corporation ("Holdings") in 2012.
Following a 2018 Holdings bankruptcy, the SHO board and a special committee of three directors determined that a Hometown liquidation had value, but preferred a transaction with the majority stockholder. The committee invited the majority stockholder to bid for Hometown or SHO as a whole and ultimately set a deadline for the majority stockholder to propose to acquire Hometown or SHO as a whole, or SHO would start a Hometown liquidation.
On the deadline, with no hope of reaching agreement, and believing that the committee would move forward with the Hometown liquidation, the majority stockholder took action by written consent as SHO's majority stockholder to: (i) amend SHO's bylaws to require that a Hometown liquidation receive approval from 90% of the board at two separate votes taken at least 30 business days apart and (ii) remove two of the committee members from the board and fill the resulting board vacancies with individuals suggested by a friendly fund.
By the end of May 2019, the majority stockholder and the remaining member of the committee negotiated a transaction for the majority stockholder to indirectly acquire SHO with a go-shop for the Outlet business. The merger agreement was not conditioned on a majority-of-the-minority approval. In August 2019, as a result of the go-shop, SHO closed the sale of the Outlet business to a third party, and the majority stockholder indirectly acquired the remainder of SHO. After the transaction was completed, minority stockholders of SHO brought suit.
The court confirmed that a controlling stockholder's exercise of its voting power to block board action, even if it blocks the board from a chosen course of action that it believes is in the corporation's best interest, is not inequitable per se. Rather, a court reviews to ensure that the stockholder properly exercised its voting powers and acted in accordance with its fiduciary duties. A controlling stockholder does not owe enforceable duties when declining to sell, declining to vote, or voting against a change to the status quo—controllers are entitled to use their voting power to maintain the status quo and protect themselves. However, a controlling stockholder voting to change the status quo owes duties of loyalty (requiring it not to intentionally harm the corporation or the minority) and care (requiring it not to harm the corporation or the minority through grossly negligent action).
The court applied enhanced scrutiny (a standard previously only applied to director's actions) in reviewing the majority stockholder's actions as a controlling stockholder because its actions impaired the rights of the directors or a stockholder minority. The court held that the majority stockholder did not breach its fiduciary duties when it amended the bylaws and removed/replaced the directors. Rather, (i) it acted in good faith, after a reasonable investigation, to achieve a legitimate objective that it had a reasonable basis for believing was necessary, and (ii) it selected a reasonable means for achieving its legitimate objective.
In particular, the court found that the majority stockholder acted properly and reasonably to prevent the destruction of value that it believed the liquidation would cause. The bylaw amendment did not prevent the committee or the board from acting, but it prevented them from unilaterally implementing the liquidation. Further, the majority stockholder only removed two directors and replaced them with individuals whom it did not control but who would support its interests. The court commented that "if events had stopped with the controller intervention … then judgment would be entered for the defendants."
Next, consistent with MFW, the court reviewed the majority stockholder's acquisition of SHO, which eliminated the minority stockholders, applying entire fairness. The court determined that the business judgment rule did not apply because the acquisition of SHO by the majority stockholder did not utilize both a duly empowered committee and a majority of the minority vote. The court held that the majority stockholder breached its fiduciary duties in connection with the acquisition because it did not pay a fair price for SHO after examining the Outlet and Hometown components of the acquisition separately. In looking at the acquisition as a whole, the court also held there was not a fair process because the "heavy handed" tactic of removing two of the three committee members along with the allocation of net consideration and negotiation history were evidence of unfair dealing.
Three Key Takeaways
- Controlling stockholders owe fiduciary duties of loyalty and care to the corporation and minority stockholders when they exercise stockholder-level voting power to change the status quo, but they do not assume the duty of acting affirmatively to promote the best interests of the corporation to which directors are subject.
- Enhanced scrutiny applies to review of fiduciary duties in connection with the exercise of stockholder-level voting power to change the status quo that impairs the rights of directors or minority stockholders.
- Exercise of stockholder-level voting power to change the status quo, while not a breach of fiduciary duties itself, can influence whether a transaction is "entirely fair." Controlling stockholders effecting squeeze-out transactions should continue to consider securing the structural protections of a special committee and a majority-of-the-minority vote to earn business judgment rule deference.
