July 23, 2021

An Entirely Fair Transaction Might Still Be Inequitable or Unjustified, and Must be Reviewed on That Basis

A common maxim under Delaware law is that “inequitable action does not become permissible simply because it is legally possible.” Schnell v. Christ-Craft Indus., Inc., 285 A.2d 437, 439 (Del. 1971). Consistent with that, actions taken by corporate directors are “twice tested, first for legal authorization, and second [for] equity.” Bäcker v. Palisades Growth Capital II, L.P., 246 A.3 81, 96–97 (Del. 2021) (internal quotations omitted).

Leaning on that precedent, in Marion Coster v. UIP Companies, Inc., et al., No. 49, 2020 (Del. June 28, 2021) the Delaware Supreme Court reversed the Delaware Court of Chancery’s conclusion that defendant UIP’s board did not breach its fiduciary duties with respect to a stock sale because the transaction was subject to a fair price and a fair process. The supreme court reasoned that while the stock sale may have satisfied entire-fairness review, the Court of Chancery should have considered whether the board acted for the inequitable goal of diluting a stockholder’s interest in UIP below 50% in order to block her attempts to elect directors and in an effort to avoid a court-appointed custodian to resolve an ongoing deadlock. In remanding the action back to the Court of Chancery, the Delaware Supreme Court instructed that if “the board acted for inequitable purposes or in good faith but for the primary purpose of disenfranchisement without a compelling justification, [the Court of Chancery] should cancel the Stock Sale and decide whether a custodian should be appointed for UIP.”

Factual Background

In 2011, UIP, a Delaware real estate investment services company, was owned 50% by its board chairman Steven Schwat and 50% by plaintiff’s husband, Wout Coster. Wout died in 2015, but before that, he discussed a buyout of his interest with UIP, but was unable to reach an agreement.

After Wout Coster’s death, his 50% stake in UIP was left to his wife, plaintiff Marion Coster. At the time, the company’s board was comprised of Schwat and two UIP employees who were aligned with him, Peter Bonnell and Stephen Cox. Like her husband before her, Marion Coster continued discussions with UIP to purchase her 50% interest in the company. No agreement was reached. At various points in 2018, Marion Coster and Schwat convened stockholder meetings, during which each stockholder voted down each other’s proposals to add or remove director seats and to elect directors, resulting in deadlock.

On June 15, 2018, Marion Coster petitioned the Court of Chancery to appoint a custodian to break the deadlock (“Custodian Action”). The defendants, UIP, Schwat and Schwat Realty LLC, obtained an extension, allowing them until July 27, 2018, to answer the lawsuit. The defendants then hired the McLean Group LLC (“MGL”) to value UIP, and pushed MGL to prepare the valuation prior to the deadline for the answer. At some point, the defendants changed their minds, and decided to answer the complaint before receiving the valuation report. Once Schwat received the valuation report, he shared his change of urgency, instructing MGL not to hurry and to ensure that it believed its valuation was “truly fair.” MGL then submitted a revised report with some inconsequential changes and the same valuation.

On August 14, 2018, the UIP board approved a sale of one-third of the company’s authorized, but unissued, stock to Bonnell, who had been promised an opportunity to purchase equity in UIP (the “Stock Sale”). The defendants then amended their answer to signal an intent to seek a judgment that the Custodian Action was moot because Bonnell’s addition as a stockholder resolved the deadlock. The defendants’ conduct caused Marion Coster to file another action before the Court of Chancery, alleging that the Stock Sale constituted a breach of fiduciary duty because it was undertaken to disenfranchise her. Marion Coster’s two actions were consolidated and proceeded to trial in April 2019.

Analysis

Following trial, the Court of Chancery found that:

  • the defendants “obviously desired to eliminate plaintiff [Coster]’s ability to block stockholder action, including the election of directors, and the leverage that accompanied those rights”;
  • the timing of the Stock Sale and the defendant’s amended answer in the Custodian Action made clear that mooting that litigation was the primary driver of the Stock Sale;
  • the Stock Sale was intended to retain Bonnell, an “essential” employee; and
  • the appointment of a custodian would have been harmful to UIP, as it would constitute an event of default thereby threatening “a substantial amount of UIP’s revenue streams.”

The Court of Chancery held that the defendants did not breach their fiduciary duty because the Stock Sale satisfied the rigorous entire-fairness standard — rendering the UIP board’s apparently inequitable motives “beside the point.”

On appeal, the plaintiff argued that the Court of Chancery should have reviewed not just the fairness of the price and process, “but also the context in which the Stock Sale occurred — a conflicted board approved the Stock Sale to defeat [plaintiff] Coster’s voting rights and the leverage that came from the exercise of those rights, entrench the existing board, and interfere with her statutory right to petition for court appointment of a custodian.” The plaintiff further asserted that although the UIP board had the legal right to issue stock to Bonnell, under the existing conditions, the board had to prove that it had a compelling justification for the stock issuance.

The Delaware Supreme Court agreed with the plaintiff, concluding that the lower court should have considered plaintiff Coster’s arguments that the board approved the Stock Sale for inequitable reasons, or in good faith but for the primary purpose of interfering with the plaintiff’s voting rights without a compelling reason.

In explaining its rationale, the Delaware Supreme Court began with the long-accepted reality that a board of directors cannot escape judicial review of its actions by pointing to the legal authorization to undertake a given act. Schnell, 285 A.2d at 439 (holding that the board’s purposeful manipulation of the election machinery to entrench themselves violated the board’s duty to act equitably toward stockholders). While noting that “careful judicial scrutiny will be given [to] a situation in which the right to vote for the election of successor directors has been effectively frustrated and denied,” (Giuricich v. Emtrol Corp., 449 A.2d 232, 239–40 (Del. 1982)), the supreme court emphasized that it is against Delaware law for directors to act intentionally in an effort to disrupt stockholders’ ability to vote. Stroud v. Grace, 606 A.2d 75, 91 (Del. 1992). Moreover, under Blasius Indus., Inc. v. Atlas Corp., 564 A.2d 651 (Del. Ch. 1988), if the board’s conduct serves the primary purpose of impeding with stockholders’ right to vote (whether successful or not), the board must prove a “compelling justification” for its actions. See also, MM Cos., Inc. v. Liquid Audio, Inc., 813 A.2d 1118 (Del. 2003).

The Delaware Supreme Court identified a number of undisputed facts supporting the conclusion that the UIP board approved the Stock Sale for inequitable reasons:

  • The Stock Sale occurred while buyout negotiations stalled between UIP’s two equal stockholders;
  • The stockholders could not elect a new board because of the deadlock, which led to the Custodian Action;
  • A majority of the board members approving the sale were interested in the Stock Sale;
  • Schwat and Bonnell were friends and appeared to be aligned in negotiations against plaintiff Coster and her late husband with respect to the sale of their 50% stake in UIP;
  • Schwat and Bonnell “worked together to develop the plan to moot the Custodian Action and neutralize the threat of [Coster] controlling the Company”;
  • The defendants were “in a rush for the [MGL] [V]aluation” until the defendants decided to answer the plaintiff’s complaint and then filed an amended answer, announcing their intention to move for judgment on the pleadings because the Custodian Action had been mooted by the Stock Sale;
  • The Stock Sale put UIP stock in the hands of fellow board member Bonnell, who was aligned with Schwat and the holdover board;
  • The Stock Sale entrenched the existing board in control of UIP; and
  • “Defendants obviously desired to eliminate Plaintiff’s ability to block stockholder action, including the election of directors, and the leverage that accompanied those rights.”

Absent from the trial record, however, was a compelling justification for any of the suspect conduct, the Delaware Supreme Court underscored. As a result, the supreme court remanded the plaintiff’s claims to the Court of Chancery to apply the appropriate analyses under Schnell and Blasisus.

Takeaway

The primary lesson from Coster v. UIP is: That which is legal may not be equitable, and that which is inequitable may be prohibited under Delaware law.

It is not unheard of for a corporate board to structure a transaction or some board action in a manner that seeks to avoid a stockholder vote. While these approaches often do not violate the Delaware General Corporation Law or breach any of the company’s governing documents, the board must ensure that the conduct is taken in good faith and that there is compelling justification for the action. That requirement remains in place even if the transaction meets the entire-fairness standard.

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