• The Court of Chancery Finds a Disclosure Violation in Connection with a Notice Informing Stockholders of Action by Written Consent
  • August 5, 2009
  • Law Firm: Richards, Layton & Finger, P.A. - Wilmington Office
  • In Dubroff v. Wren Holdings, LLC, C.A. No. 3940-VCN (Del. Ch. May 22, 2009), the Court of Chancery (i) dismissed an overpayment claim by former stockholders in connection with the recapitalization of Nine Systems Corporation ("NSC") for lack of standing because the plaintiffs failed to allege sufficiently that the stockholders who approved the transaction formed a stockholder control group, and (ii) found that the plaintiffs stated a claim for breach of the fiduciary duty of disclosure in connection with the notice sent to the stockholders of NSC pursuant to Section 228 of the General Corporation Law of the State of Delaware.

    Defendants Wren Holdings, LLC, Javva Partners, LLC and Catalyst Investors, L.P. (collectively, the "Entity Defendants") collectively owned 56% of the outstanding stock of NSC. In August 2002, NSC carried out a recapitalization transaction, approved by the written consent of the Entity Defendants, by which the Entity Defendants converted the subordinated debt they each held into convertible preferred stock (the "Recapitalization"). As a result, the Entity Defendants increased their ownership of NSC stock from approximately 56% to 80%, while the remaining stockholders of NSC were greatly diluted. The plaintiffs, former stockholders of NSC, who were cashed out as part of a transaction subsequent to the Recapitalization, brought an overpayment claim based on the Recapitalization and challenged the sufficiency of the notice informing them of the Recapitalization.

    The Supreme Court has held that an overpayment claim, which classically is derivative, can also be a direct claim where a controlling stockholder causes the company to issue more equity to the controlling stockholder at the expense of the minority stockholders.1 The plaintiffs argued that the Entity Defendants – none of which alone was individually a controlling stockholder – collectively formed a controlling stockholder group. Although the Court recognized the viability of such a "control group" theory, the complaint contained no facts that taken as true would establish that the Entity Defendants had formed a control group – by contract, common ownership, agreement or other arrangement – to work together toward a shared goal. Rather, the complaint merely alleged that the Entity Defendants had parallel interests, which is insufficient as a matter of law to support an inference that the stockholders acted as a control group. As such, the Court dismissed the overpayment claim for lack of standing.

    The Court next addressed the disclosure claim. Under Section 228(e), "[p]rompt notice of the taking of the corporate action without a meeting by less than unanimous written consent shall be given to those stockholders . . . who have not consented in writing." After the completion of the Recapitalization, NSC's nonconsenting stockholders received a notice, which provided, in part: "[NSC] has recapitalized by converting its outstanding subordinated debt into shares of several new series of convertible preferred stock, and by declaring and implementing a one-four-twenty [sic] reverse stock split on all outstanding shares of common stock of the Company." The notice did not, however, inform the stockholders that the Entity Defendants were the primary recipients of the new convertible preferred stock; nor did it inform the stockholders of the pricing of the conversion of the Entity Defendants' debt into convertible preferred stock. The plaintiffs argued that they were injured by this lack of disclosure because had the notice contained such information, they could have made a claim for rescissory relief.

    The Court recognized that Delaware case law has not addressed whether notice under Section 228(e) requires a fulsome disclosure akin to that required when stockholder approval is being solicited. The Court left that inquiry for another time, however, finding that regardless of the precise scope of required disclosure, the plaintiffs have stated a claim for breach of fiduciary duty. The Court reasoned that if the requirements under Section 228(e) were akin to a disclosure seeking a stockholder vote, i.e., to disclose all material information, the plaintiffs have pled facts sufficient to establish that the board materially misled stockholders. If, on the other hand, the disclosure standard is less fulsome in this context, the Court still could reasonably infer that the board deliberately omitted material information with the goal of misleading the plaintiffs and other stockholders about the Entity Defendants' material financial interest in and benefit conferred by the Recapitalization. Under Delaware law, no matter what context, whenever directors communicate publicly or directly with stockholders about corporate matters, they must do so honestly. Thus, the Court determined that regardless of the scope of disclosure required pursuant to Section 228(e), the plaintiffs have sufficiently pled a disclosure violation.

    1Gentile v. Rosette, 906 A.2d 901 (Del. 2006).