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Minority Stockholders Can Owe Fiduciary Duties

—Jeffrey W. Apel

There appears to be a recent trend in Delaware courts towards increased scrutiny of transactions involving controlling stockholders.  Most practitioners are probably familiar with the concept that a stockholder that owns a majority of a corporation’s voting stock, and is therefore considered a “controlling stockholder”, can owe certain fiduciary duties to the corporation’s minority stockholders under certain circumstances, most notably in the context of mergers, changes of control, and tender offers.  A recent Delaware Chancery Court opinion, Calesa Associates LP et al. v. American Capital, reinforces the idea that a minority stockholder may also owe a fiduciary duty to the corporation’s stockholders in certain circumstances.

The setup in Calesa is a common one in venture capital and private equity transactions. Defendant American Capital, Ltd., a publicly-traded private equity firm, initially held, together with its affiliates (collectively, “ACAS”), a 26% equity interest in Halt Medical, Inc. (“Halt”) after making an $8.6M investment in the company.  In connection with the initial investment, ACAS was granted the right to appoint two of the 5 directors and the right to block subsequent investments in Halt.  After Halt’s board of directors negotiated a potential deal with investors for a $35M loan at a 15% interest rate, ACAS exercised its blocking right, offering instead to loan Halt $20M at a 22% interest rate with the right to appoint one additional director.  ACAS accepted Halt’s offer notwithstanding the less favorable terms from ACAS.  As the loan reached its maturity date, despite indications that ACAS would extend the note, ACAS unexpectedly demanded repayment in full.  Faced with the impending maturity of an aggregate $50M in loans and the company’s failure to secure additional financing, ACAS demanded that Halt enter into a merger transaction pursuant to which ACAS’s ownership in Halt increased from approximately 26% to 66%, with ACAS controlling four of the seven board seats.  The plaintiffs alleged that ACAS received a disproportionate benefit from such transaction, representing an unfair price to the plaintiff stockholders, and that only after the transaction was completed did ACAS’s true motive emerge: starving Halt and ensuring the dilution of the plaintiffs’ interests and the cancellation of their preferred stock, all in order to “squeeze” the minority investors out of the company and seize the value of the company for itself.

The plaintiff stockholders alleged that (1) ACAS owed a fiduciary duty to the Halt’s other stockholders because ACAS could be deemed a controlling stockholder given ACAS’s actual control of Halt’s board of directors and (2) ACAS breached its fiduciary duties by promoting its own interests over the interests of the plaintiff stockholders.  In focusing on a stockholder’s influence over the company’s board of directors, the court reaffirmed that “control” is a highly fact-specific inquiry and there is no magic formula to find control. Ultimately, the court found that the plaintiff’s allegations were enough to find that a majority of the board of directors was not independent or disinterested, that ACAS was indeed a controlling stockholder that owed fiduciary duties to Halt’s other stockholders.  Notably, the court was not persuaded by the defendant’s argument that it was merely exercising certain contractual rights that gave it a superior bargaining position.

Stockholders that own a minority interest in a company should keep in mind that courts will not simply rely on a bright-line ownership test to determine control.  When engaging in related-party transactions in which a stockholder is on both sides of the table, even a minority stockholder should ensure there are procedural safeguards in place such as having the transactions approved by independent directors or by other informed and unaffiliated stockholders.

The information in this article is for informational purposes only and does not constitute formal, legal advice.  Consult with one of the attorneys from Roberts McGivney Zagotta LLC for advice about your particular circumstance.