Board's Lack of Independence from Interested Director Excuses Stockholder Demand as Futile
In Sciabacucchi v. Liberty Broadband Corp., et al., C.A. No. 11418-VCG (Del. Ch. July 26, 2018), the Delaware Court of Chancery denied in part a motion to dismiss brought by defendants Liberty Broadband Corporation (“Liberty”), Liberty’s largest stockholder, and the board of directors of Charter Communications, Inc. (“Charter,” and collectively “Defendants”), for failure to plead demand futility. The Court ruled that the Plaintiff, a stockholder of Charter, pleaded sufficient facts to support a reasonable inference that the influence of Liberty’s largest stockholder would prevent the Charter board of directors from exercising independent and disinterested business judgment when considering a demand to bring a lawsuit on behalf of the corporation.
In order to appreciate the issues involved, it is first necessary to understand the ownership structure and director composition of Charter, one of the largest cable providers in the United States. Charter’s largest stockholder is Liberty, which owns approximately 26% of Charter. Pursuant to the terms of a pre-existing stockholders agreement, Liberty has the right to designate four directors to Charter’s 10-person board of directors. John Malone (“Malone”) owns 47% of Liberty, is the chair of the Liberty board of directors, and is one of Liberty’s four designated directors on the Charter board. Charter’s certificate of incorporation limits its ability to engage in certain transactions (such as the issuance of securities) with holders of 10% or more of its voting stock (such as Liberty) unless such transaction is approved by a majority of the Charter directors unaffiliated with the interested stockholder and a majority of Charter stockholders unaffiliated with the interested stockholder.
In 2015 Charter acquired two companies in its same industry, Time Warner Cable (“TWC”) and Bright House Networks, LLC (“Bright House”). While TWC agreed to merge with Charter for a mix of cash and Charter shares, the merger agreement provided that Liberty, as a TWC stockholder, would receive only Charter stock in exchange for its TWC shares. Further, upon closing of the TWC merger, Liberty agreed to purchase $4.3 billion of newly issued Charter shares at $176.95 per share. Charter simultaneously announced that it had reached an agreement to acquire Bright House. As a result of the Bright House acquisition, Liberty would receive a 6% voting proxy in Charter (the “6% Voting Proxy”) to maintain its pre-acquisition voting power and also agreed to purchase $700 million of newly issued Charter shares at $173 per share. The TWC and Bright House deals were contingent upon Charter obtaining stockholder approval of the aforementioned issuances of stock and the 6% Voting Proxy.
The four Charter directors designated by Liberty unanimously approved the TWC and Bright House acquisitions as being fair and in the best interests of the Charter stockholders. The six unaffiliated directors unanimously approved the TWC and Bright House acquisitions as well as the issuances to Liberty of stock and the 6% Voting Proxy. After approximately 86% of outstanding Charter shares (excluding shares beneficially owned by Liberty) voted to approve the transactions, the TWC merger and Bright House acquisition closed.
Plaintiff did not challenge the TWC and Bright House deals. Instead Plaintiff alleged that the Charter directors breached their fiduciary duties by approving the issuance to Liberty of Charter stock and the 6% Voting Proxy, as they were not made in exchange for sufficient consideration. Defendants moved to dismiss on the grounds that (i) the stockholder vote had cleansed any breaches of duty by the Charter board of directors; (ii) the claims in the Complaint were derivative in nature and failed to satisfy the demand requirement in the applicable Chancery Court rule; and (iii) the Complaint failed to adequately state a claim under Rule 12(b)(6). In May 2017, the Court issued its opinion in Sciabacucchi v. Liberty Broadband Corp., (“Sciabacucchi I”), holding that Liberty and Malone were not controlling stockholders of Charter and any alleged breaches of fiduciary duty by the Charter directors were not cleansed by the subsequent stockholder vote, because approval of the stock issuances and 6% Voting Proxy were presented to the stockholders in a coercive manner
The issues remaining after the Court issued its opinion in Sciabacucchi Iare: (i) whether the directors breached their fiduciary duties by approving the stock issuances and 6% Voting Proxy, and (ii) whether the directors failed to disclose all material facts necessary for stockholders to cast an informed vote on the transactions. Plaintiff brought this as both a direct and derivative claim.
The Court began its analysis by characterizing the instant action as a “corporate overpayment case,” because Plaintiff alleged that Charter issued to Liberty stock and the 6% Voting Proxy for unfair consideration. Although a typical corporate overpayment case is derivative in nature, the Delaware Supreme Court in Gentile v. Rossette identified one species of corporate overpayment case as being both derivative and direct. This dual-natured claim arises in situations where (i) a stockholder has majority or effective control and causes the corporation to issue excessive shares of its stock in exchange for assets of the controlling stockholder that have a lesser value, and (ii) the exchange causes an increase in the percentage of the outstanding shares owned by the controlling stockholder and a corresponding decrease in the share percentage owned by the public (minority) shareholders. The Court explained that Gentile has been construed to apply to situations involving a dilutive stock issuance to a controlling stockholder (i.e., a majority stockholder or a stockholder exercising control over the business affairs of the corporation). Because the Court held in Sciabacucchi I that Plaintiff failed to adequately allege that Liberty and Malone were controlling stockholders of Charter, it concluded that the instant claims were not dual-natured under Gentile and therefore solely derivative.
Next, the Court undertook to decide whether Plaintiff complied with the demand requirement by “alleg[ing] with particularity the efforts, if any, made by the plaintiff to obtain the action the plaintiff desires from the directors or comparable authority and the reasons for the plaintiff’s failure to obtain the action or for not making the effort.” Where, as is the case here, Plaintiff fails to make demand on the board of directors, the Court must dismiss the Complaint unless it alleges with particularized facts that demand would have been futile. Under Delaware law, a presumption exists that directors are independent for purposes of evaluating demand futility unless the Plaintiff establishes that the directors are subject to influence by an interested director, which would serve to undermine the board’s ability to judge the matter on the merits.
Plaintiff argued that demand on Charter’s board was futile because at least half of the 10-person board lacked independence from an interested director, Malone. Because Defendants conceded that Malone, along with one other director, lacked independence, the Court evaluated the remaining directors and found that the Complaint supported a reasonable inference that three additional directors (totaling half of Charter’s 10-person board of directors) lacked independence from Malone. The Court found that one director (Nair), who was a designated director of Liberty, was not independent from Malone because he worked at a company (Liberty Global, plc) where Malone was the largest stockholder and chairman of the board of directors, which put Malone “in a position to exert considerable influence over” him. The Court found that a second director (Rutledge) lacked independence from Malone because he was a highly compensated executive of Charter, whose largest shareholder is Liberty, which is in turn owned 47% by Malone. This finding was further buttressed by a New York Times article in which Rutledge did not deny Malone’s influence, stating: “[w]hen [Malone] talks, I listen. And he is a significant talker.” Finally, the Court found that the Complaint supported a reasonable inference that a third director (Zinterhofer) lacked independence from Malone because he was engaged in “material” business ventures with Malone, through Liberty Global, worth nearly $1 billion. Accordingly, the Court concluded that at least half of Charter’s 10-person board of directors lacked independence from Malone and therefore excused demand as futile.
The Court’s finding that the Charter board lacked an independent and disinterested majority had an important consequence–it rebutted the business judgment rule and required the Court to review the board’s decision for entire fairness, which typically precludes a dismissal for failure to state a claim on which relief can be granted. Because the standard for pleading demand futility is more stringent than the standard for failure to state a claim on which relief can be granted, a complaint surviving a motion to dismiss on grounds of demand futility will also survive a motion to dismiss for failure to state a claim on which relief can be granted, as long as it states a cognizable claim. Defendants, however, argued that the issuance to Liberty of stock and the 6% Voting Proxy were approved by the six directors not designated by Liberty, and therefore in order to successfully rebut the business judgment rule Plaintiff must attack the independence of the six unaffiliated directors. The Court rejected this argument, reasoning that although the four directors designated by Liberty did not vote on the challenged transactions, they approved of the coercive structure of the stockholder vote and therefore helped “strong-arm” the stockholders into voting for the challenged transactions for reasons other than the economic merits. As the six unaffiliated directors were placed in identical circumstances, the Court held that Plaintiff only needed to plead that at least half of the 10-person board lacked independence from Malone, which he had successfully done.
Finally, the Court dismissed Plaintiff’s disclosure claim, which alleged that Charter would not have overpaid Liberty if the proxy had not included “materially misleading” claims. The Court explained that this result is compelled by Delaware case law when identical compensatory damages are sought in both a direct disclosure claim and a derivative corporate overpayment claim.