The Corporate Guide: Avoiding Enhanced Scrutiny of Transactions Involving Controlling Stockholders

How does Delaware law define a controlling stockholder?

Typically, a stockholder is “controlling” if the stockholder owns more than 50% of the voting power in a corporation or “exercises control over the business affairs of the corporation.” Kahn v. Lynch Communc’n Sys., Inc., 638 A.2d 1110, 1113-14 (Del. 1994).

• Exercising control does not have a fixed legal meaning. As a practical matter, it means the stockholder “possesses a combination of stock voting power and managerial authority that enables [the stockholder] to control the corporation...” In re Cystive S’Holders Litig., 836 A.2d 531, 553 (Del. Ch. 2003).
• Control does not mean oversight of the corporation’s day to day operations. Rather, it is sufficient that the stockholder had influence or control over the transaction at issue.

The following are common factors considered by Delaware courts in deciding if a minority stockholder has dominion or control over the corporation’s board of directors — although none of these factors alone proves control:

• Circumstances indicating influence over other board members, even absent evidence that influence was used.
• Veto ability over the decisions and actions of the board.
• Whether the minority stockholder was CEO, founder or chair of the board and length of tenure in those positions.
• The degree of involvement of the minority stockholder in the day-to-day running of the company.
• Preferential treatment by the board.
• The employment of family members of the minority shareholder by the company.
• Direct threats or commands by the minority stockholder to the board.
• The minority stockholder’s control over important customers of the company.

What are some examples where the Delaware Court of Chancery has found a minority stockholder to be controlling?

• Williamson v. Cox Communications, Inc., 2006 WL 1586375, at *5 (Del. Ch. June 5, 2006): The Court of Chancery found that it was reasonably inferable that two stockholders, who together held a 17.1% stake in the relevant corporation, were controlling stockholders because they could “shut down the effective operation of the [corporation’s] board of directors by vetoing board actions.”
• In re Zhongpin Inc. Stockholders Litig., 2014 WL 6735457 (Del. Ch. Nov. 26, 2014) (rev’d on other grounds): The Court of Chancery concluded that the complaint pleaded sufficient facts to raise the inference that the company’s CEO, chairman, and 17.3% stockholder was a controlling stockholder. Evidence of the CEO’s control was found in the company’s Form 10-K, which stated that he “exercise[d] significant influence over” the company. Id. at *7. Examples of the CEO/chairman/stockholder’s control included the right to:
  • Approve the election of directors
  • Select senior management
  • Receive significant dividend payments
  • Influence mergers and acquisitions
  • Amend the company’s bylaws
  • Manage the company’s operations and daily business
• Calesa Assoc., L.P, et. al. v. American Capital, Ltd., 2016 WL 770251 (Del. Ch. Feb. 29, 2016): The Delaware Court of Chancery held that the plaintiffs, stockholders of Halt, adequately alleged that American Capital, which owned only a 26% equity stake in Halt, exercised complete control and dominion over Halt and its board. The allegation that American Capital was Halt’s controlling stockholder was based on the following:
  • In connection with its initial investment in Halt, American Capital received the right to appoint two of Halt’s five directors.
  • American Capital had the right to block or veto certain equity transactions.
  • In 2011, Halt obtained a third-party loan secured by its intellectual property. American Capital “secretly” purchased the resulting note and the secured interest.
  • Also, in 2011, American Capital blocked another third-party loan and forced Halt’s board to accept a $20 million loan from American Capital at a 22% interest rate. By virtue of that loan, American Capital received the right to appoint another member to Halt’s board of directors.
  • When Halt was incapable of repaying the loans, American Capital forced Halt into a transaction whereby American Capital would loan Halt an additional $73 million ($55 million of which would be used to repay the original indebtedness) in exchange for new shares of preferred and common stock.
  • The resulting transaction gave American Capital 66% of Halt’s outstanding stock and the right to designate four of Halt’s six director positions.
  • Halt’s CEO, who was also a director, was beholden to American Capital because his employment could be terminated by American Capital.

How can a company ensure that controlling-person transactions benefit from the business judgment standard of review and insulate those transactions from enhanced scrutiny?

• Transactions where a controlling stockholder stands on both sides typically are reviewed under the onerous entire-fairness standard. Weinberger v. UOP, Inc., 457 A.2d 701, 710 (Del. 1983); In re Cystive S’Holders Litig., 836 A.2d 531, 547 (Del. Ch. 2003).
• Under that standard, the directors bear the burden of establishing that the challenged transaction was entirely fair to the company.
• A company’s board, however, can secure business-judgment review of transactions involving controlling stockholders if:

1. The transaction is approved by both a special committee and a majority of the minority of disinterested stockholders.
2. The special committee is independent of the controlling shareholder.
3. The special committee has power to reject the proposal and may rely on the guidance of independent legal and financial advisors.
4. The special committee meets its duty of care.
5. The minority vote is nonwaivable, fully informed and uncoerced.
   In re MFW Shareholders Litig., 67 A.3d 496 (Del. Ch. 2013) (then-Chancellor Strine held that such a process provides significant minority protection because a special committee ensures “that there is a bargaining agent who can negotiate price and address the collective action problem facing shareholders” and the “majority-of-the-minority vote provides stockholders a chance to vote on a merger proposed by a controller-dominated board.”)

Key Takeaways

• When engaging in transactions involving individuals or entities with a significant equity position in the company, the board must scrutinize the conduct of that stockholder to determine whether, based on the factors explored above, that stockholder could be classified as having control or dominion over the company or its board.
• If the company is considering a controlling-person transaction, it should form a special committee comprised of directors who are independent from the controlling stockholder and are disinterested in the transaction, and maintain a record of how it was determined that the committee members are disinterested (such as questionnaires).
• The board must ensure that the special committee has the unfettered right to negotiate and reject the controlling stockholder’s proposal or preferred transaction.
• The special committee should exercise the oversight over the transaction, and the rest of the board (and certainly directors lacking independence) should not have any role in negotiating or structuring the transaction.
• The board must ensure that the minority stockholders are provided with disclosures containing all material information regarding the contemplated transaction, free from any materially misleading information.
• From the beginning of negotiations through the finalization of the transaction, it must be subject to the approval of disinterested, minority stockholders.

Given the complexity of issues involving controlling stockholders, the importance of a careful process, and the likelihood of litigation, it is recommended to engage experienced outside counsel as soon as such transactions are contemplated.