Court of Chancery Applies Entire Fairness Standard to PennyMac’s Reorganization Transaction
In Robert Garfield v. BlackRock Mortgage Ventures, LLC, et al (the “Defendants”) (C.A. No. 2018-9017-KSJM), the Court of Chancery denied a motion to dismiss claims of breach of fiduciary duties filed by Robert Garfield (the “Plaintiff”), an investor that claims a reorganization of Private National Mortgage Acceptance Company, LLC (“PennyMac, LLC”) was unfair to certain stockholders. The Court of Chancery found that the complaint stated a claim when evaluated under the entire fairness standard of review where stockholders constituting a “control group” stood to benefit from the transaction.
PennyMac, LLC was formed by BlackRock, Inc. (“BlackRock”) and Highfields Capital Management (“HC Partners”) in the wake of the financial crisis of 2008. As founding co-sponsors, BlackRock and HC Partners had the right to veto certain LLC actions and call official meetings. Shortly thereafter, PennyMac formed PennyMac Mortgage Investment Trust (the “Public REIT”), which was externally managed by a subsidiary of PennyMac, LLC, PNMAC Capital Management, LLC.
In 2013, BlackRock, HC Partners and a former CEO of PennyMac, took the PennyMac, LLC structure public in an “Up-C” transaction. After the initial public offering, a new publicly traded corporation known as PennyMac, Inc. (“PennyMac, Inc.”) became the parent corporation of PennyMac, LLC (collectively, “PennyMac”). PennyMac, Inc. issued Class A common stock to its stockholders and Class B common stock to existing LLC unitholders in PennyMac, LLC. The Class A common stockholders owned 15% of the voting rights and the Class B common stockholders owned 85% of the voting rights. As part of the “Up-C” transaction, the LLC unitholders were allowed to exchange their LLC units for Class A common stock in PennyMac, Inc. on a one-for-one basis and were entitled to payment of 85% of any tax benefit to PennyMac, Inc. as a result of the exchange.
Ultimately, the tax benefit to the LLC unitholders did not come to fruition because of the passage of the Tax Cuts and Jobs Act of 2017, which reduced the top marginal federal corporate tax rate from 35% to 21% and as a result reduced the expected future value of PennyMac, LLC’s tax assets. Additionally, PennyMac, LLC deferred revenue due to its loan production volume growth resulting in current period tax losses. In 2018, a capital structure reorganization was proposed to PennyMac’s Board of Directors (the “Board”) to address the LLC unitholder’s shortfall.
The Board met with management several times and formed a special committee to evaluate the reorganization. The special committee met with management and discussed the reorganization with BlackRock and HC Partners, but no other stockholders. Ultimately, the special committee recommended and the Board approved the reorganization and a distribution of $10.1 million to Class A common stockholders.
The Plaintiff, a Class A common stockholder, filed a lawsuit in 2018 and later amended its complaint, alleging breach of fiduciary duty derivatively and on behalf of a proposed class against PennyMac’s directors and the Defendants in connection with the reorganization of PennyMac’s corporate structure. The Plaintiff claimed that the stockholder vote was uninformed as to projections of PennyMac’s future profitability and the tax benefits for the LLC unitholders. In particular, certain projections were only provided to BlackRock and HC Partners, but none of the other stockholders.
Plaintiff argued that BlackRock and HC Partners comprised a “control group” and therefore the entire fairness standard should apply to the transaction as opposed to the business judgment standard. Plaintiff contends that multi-year historical and transaction-specific ties between BlackRock and HC Partners amounted to a “control group”. Plaintiff pointed to a ten-year history of co-investment by BlackRock and HC Partners in PennyMac, including as founding sponsors and as “strategic investors” in the Public REIT IPO and the “Up-C” public offering. Plaintiff also pointed to joint meetings between PennyMac’s management, BlackRock and HC Partners to negotiate the reorganization, which granted them preferential review and exclusive discretion to weigh in before the Board considered the proposal. BlackRock and HC Partners were also given an exclusive right to require their consent to the termination of the reorganization.
Defendants filed a Rule 12(b)(6) motion to dismiss Plaintiff’s amended complaint arguing that the business judgment standard of review under Corwin v. KKR Financial Holdings (125 A.3d 304 (Del. 2015)) should apply. According to the Defendants, a fully informed, uncoerced majority vote of disinterested stockholders approved the reorganization and therefore Plaintiff’s amended complaint failed to state a claim under the business judgment standard.
The Court of Chancery held that the entire fairness standard and not the business judgment standard should apply. In its analysis of the standard of review, the Court of Chancery referred to the factors in the “legal significant connection” test from the U.S. Supreme Court case In re Hansen Medical Shareholders Litigation. Despite the absence of a formal or written agreement pertaining to the transaction, BlackRock and HC Partners controlled approximately 46.1% of PennyMac Inc.’s voting stock, had a right to block the reorganization, shared an interest in working together to approve the reorganization and the historical and transaction-specific ties raised by the Plaintiff were sufficient to reasonably infer they were a “control group”. Under the entire fairness standard, the Court of Chancery concluded that BlackRock and HC Partners exercised effective control over PennyMac in connection with the reorganization and thus an unfair price could be inferred from the defective negotiation process. The Court denied the Defendants’ motions to dismiss.