The recent post-trial opinion by the Delaware Court of Chancery in In re Sears Hometown and Outlet Stores, Inc. Stockholder Litigation[1]puts controlling stockholders on notice that they must be mindful of their fiduciary duties to the Delaware corporations they control not only when they are engaging in transactions between themselves and these corporations, but also when selling and voting shares of these corporations.[2] Before having an alarmist reaction that every decision by a controller on whether or not to dispose of its shares or how to vote its shares may trigger a lawsuit on behalf of the minority stockholders, it is worth drilling down on this idea of fiduciary duties of a controller outside the context of a transaction or arrangement where the controller is receiving a unique or non-ratable benefit that is not available to the minority stockholders.
First, there are no fiduciary duties on the part of a controlling stockholder when the controlling stockholder is refusing to sell its shares or is voting against a change to the status quo. In contrast to a director, who has a duty to take reasonable actions to pursue the best interests of the corporation at all times, a controlling stockholder has the absolute right to “just say no” to changes to the status quo.[3] A controlling stockholder never has an affirmative obligation to sell or vote in favor of a change even if the sale or change would be in the best interests of the corporation or the minority stockholders.[4]
Second, if a controller is seeking to change the status quo without giving rise to a non-ratable benefit for the controller, then the applicable duties are of a “do no harm on purpose or recklessly” nature – specifically, a duty not to harm the corporation or its minority stockholders either intentionally or through grossly negligent action.[5] Sears sets forth three prongs for testing whether this duty has been satisfied:
- Legitimate objective. Did the controller act in good faith for a legitimate objective (i.e., an objective that the controller believed in good faith would be in the best interests of the corporation and the minority holders)?
- Reasonable basis for changing the status quo. Did the controller have a reasonable basis for believing that its action was necessary to pursue this legitimate objective?
- Reasonable means for achieving the objective. Did the controller select reasonable means to achieve this legitimate objective?[6]
In Sears, Vice Chancellor Laster applied this framework to steps that the controlling stockholder, who held more than 50% of the Company’s stock (the “Controlling Stockholder”), took to impede the board’s proposed plan to liquidate a business segment of Sears Hometown and Outlet Stores, Inc. (the “Company”).[7] A special committee of the board of the Company favored the liquidation plan, but the Controlling Stockholder, as characterized by the Court, “thought liquidating [the segment] would destroy value.”[8] The Court relates further that, after failing to convince the special committee that the liquidation plan was contrary to the best interests of the Company, the Controlling Stockholder took action by written consent, in his capacity as a majority stockholder, (i) to adopt a new bylaw amendment to impose procedural hurdles (a requirement for two supermajority board votes that were 30 days apart) to impede the adoption by the board of the liquidation plan and (ii) removed two of the directors on the special committee whom the controller believed to be the “most insistent on the liquidation plan” (collectively, the “Actions”).[9]
The Court held that even though the Actions did not give rise to any non-ratable benefit to the Controlling Stockholder, these Actions still had to comply with fiduciary duties applicable to actions by a controller that change the status quo.[10] After trial, Vice Chancellor Laster found that the Actions did not violate the fiduciary duties of the controller because the Controlling Stockholder had satisfied each of the three prongs of the applicable fiduciary duty test:
- The Controlling Stockholder had believed in good faith, based on study and experience, that the liquidation plan would be value-destructive to the Company (i.e., a good faith, legitimate objective).
- The Controlling Stockholder had identified this threat and the Actions after a good faith, reasonable investigation of the intentions of the special committee and their disregard for the adverse consequences for the Company and the stockholders arising from the proposed liquidation plan (i.e., a reasonable basis for taking action).
- The Actions were within the “range of reasonableness” for achieving the legitimate objective. The Court viewed the Actions as “drastic but necessary” to achieve the objective, and observed that the Actions were more restrained than alternatives, such as requiring board unanimity for a liquidation and broader changes to the composition of the board.[11]
Key Takeaways
How Hard Is It for Controllers to Satisfy the Sears Framework?
On its face, the Sears framework for compliance by controllers with fiduciary duties when they are changing the status quo without receiving a non-ratable benefit for themselves seems relatively easy to satisfy. In these scenarios, any rationally acting, sophisticated controlling stockholder should not have a problem satisfying the first two prongs, which basically amount to having a good faith intention to benefit this corporation which the controller has a vested interest to benefit by virtue of the controller’s equity investment.
The third prong – whether the actions by the controller are within the range of reasonableness – echoes the Court’s Revlon standard for testing whether a fiduciary has taken steps that are within the “range of reasonableness” for obtaining the best price available when selling the corporation for cash consideration. Historically, Delaware Courts have provided a relatively wide berth for fiduciaries to act and still be within the “range of reasonableness” in the context of Revlon and its progeny, and the Court in Sears does not appear to be intent on deviating from that trend.[12]
Will Dismissal on the Pleadings Be Available to Controllers Defending Future Sears Claims?
Even if compliance with the Sears framework is not burdensome, a pressing question coming out of Sears, which is a post-trial opinion, is how fiduciary duty claims brought against a controlling stockholder under this framework will be handled on a motion to dismiss. It would be problematic if every disposition or vote of shares by a controller in a manner that arguably changed the status quo (a potentially elastic concept) were to trigger a risk of a purported class action claim on behalf of the minority stockholders that could not be dismissed on the pleadings.
The Court of Chancery has granted and denied motions to dismiss Revlon claims in the past,[13] but, given the lack of case law, it is not clear how it will approach a Sears claim at the motion to dismiss stage. On the one hand, Sears involves some fact-based inquiries (which the Court may punt to trial) and controlling stockholders are not subject to monetary liability exculpation under Section 102(b)(7) of the Delaware General Corporation Law (and exculpated claims are generally dismissed); but, on the other hand, the bar to fulfilling fiduciary duties under Sears is not particularly high.
What Should Controlling Stockholders Do in Light of Sears?
We do not view the Sears opinion, by itself, as cause for a seismic shift in how controlling stockholders should interact with their respective companies and minority stockholders. In the wake of this opinion and the risk of heightened attention to scenarios where controllers are merely selling or voting and not even receiving a non-ratable benefit, we are currently advising controllers to adhere to the following protocols:
- Internal recordkeeping and documentation. Disciplined recordkeeping and document creation have been, and still are, critical factors to managing litigation risk. Controlling stockholders contemplating sales and votes to change the status quo should ensure that there is a robust paper trail to support their consistent, good faith pursuit of their “legitimate objectives” and “reasonable bases for taking the actions” (i.e., the first two prongs). If a controller is taking stockholder action by written consent, we are advising that the recitals to the consent clearly document the controlling stockholder’s rationale, as well as supporting factual understandings, for adopting the resolutions.
- Board materials. Board minutes and other board-level materials remain key to defeating a motion to dismiss. Plaintiffs typically build their complaints using documents produced by a company in response to a demand for books and records under Section 220 of the Delaware General Corporation Law, which typically is confined to board-level materials including board minutes. Those documents will essentially serve as the evidentiary record for a defendant for purposes of a motion to dismiss, and therefore detailed board minutes about the controlling stockholder’s legitimate objective and reasonable basis for its actions can help establish for the Court that the controlling stockholder fulfilled its fiduciary duties, without having to go through the costly exercise of discovery. One way for the controller to ensure that such details make it into the board and committee minutes is for the controller to meaningfully engage at formal board and committee meetings (including by arranging to attend for portions of meetings as an invited attendee if the controller does not have a representative on the board or committee). As part of this engagement with the board or committee, the controller would go on record at these meetings with explanations of and analytical support for the controller’s concerns with the status quo of the corporation, and even provide the board or committee with written materials supporting the controller’s good faith understanding of why changes to the status quo would be in the best interests of the corporation and the stockholders generally.
- Less drastic means. If a controlling stockholder decides to vote or sell its stock to change the status quo, keep in mind that, even though the “range of reasonableness” test provides a degree of deference to the controlling stockholder, the Court does not grant a controlling stockholder a blank check. If it is practicable to use less drastic means to achieve the controller’s objective, then consider doing just that.
[1] — A.3d —, 2024 WL 262322 (Del. Ch. Jan. 24, 2024). The case is currently subject to a motion for reargument (and, eventually, a possible appeal to the Delaware Supreme Court). For Vice Chancellor Laster’s personal commentary, dated February 19, 2024, about his opinion in this case, see https://www.linkedin.com/pulse/dispatch-from-tampa-sears-mundane-stockholder-votes-travis-laster-0mcle/.
[2]Id. at *23
[3]See id. (“A controlling stockholder owes fiduciary duties when exercising stockholder powers, but not the same duties a director owes.”)
[4]Id. at *25–26.
[5]Id. at *1.
[6]Id. at *30.
[7] The Sears case discusses, among other things, whether the Controlling Stockholder’s eventual buyout of the Company, which was not conditioned on a majority of the minority vote, was entirely fair. See id. at *37. This post does not discuss this aspect of the Sears opinion.
[8]Id. at *13.
[9]Id. at *1.
[10]Id. at *27.
[11]Id. at *31–34.
[12]See, e.g., Lyondell Chem. Co. v. Ryan, 970 A.2d 235, 242–44 (Del. 2009); In re Plains Exploration & Prod. Co. S’holder Litig., 2013 WL 1909124, at *5–7 (Del. Ch. May 9, 2013); In re Smurfit-Stone Container Corp. S’holder Litig., 2011 WL 2028076, at *16–24 (Del. Ch. May 20, 2011); In re Lear Corp. S’holder Litig., 926 A.2d 94, 97–98, 117–22 (Del. Ch. 2007).
[13]See, e.g., In re Mindbody, Inc., S’holders Litig., 2020 WL 5870084 (Del. Ch. Oct. 2, 2020) (denying a motion to dismiss with respect to a Revlon claim); Rudd v. Brown, 2020 WL 5494526 (Del. Ch. Sept. 11, 2020) (granting a motion to dismiss with respect to a Revlon claim).
