Court Of Chancery Applies Entire Fairness Standard To Stock Sale Approved By Interested Board Of Directors
In Marion Coster v. UIP Companies, Inc. (C.A. No. 2018-0440-KSJM) the Delaware Court of Chancery (the “Court”) addressed a dispute over the control and ownership of a company following a sale of unissued stock to a company executive. The Court applied the entire fairness standard to review the stock sale transaction and held it was fair in light of a valuation report obtained by the defendants in the case and entered judgment in favor of the defendants validated the stock issuance.
The dispute between Marion Coster (the “Plaintiff”), UIP Companies, Inc., a Delaware real estate investment services company (the “Company”), Steven Schwat, Schwat Realty LLC (the entity through which Steven Schwat holds his Company stock), Peter Bonnell, Bonnell Realty, LLC (the entity through which Peter Bonnell obtained his Company stock) and Stephen Cox (collectively, the “Defendants”) arose shortly after Plaintiff’s husband passed away. Prior to the disputed stock sale, the Company was owned equally by Steven Schwat and Plaintiff’s late husband, both of whom were co-founding principals of the Company. After the Plaintiff inherited her fifty percent interest in the Company, she and Steven Schwat repeatedly discussed and disagreed on the buyout of her ownership stake and members of the board of directors. The Plaintiff went as far as calling for special meetings of the stockholders to elect new members of the Company’s board of directors and to decrease the number of directors, but numerous motions to vote failed.
On June 15, 2018, the Plaintiff filed a complaint against the Company, Steven Schwat and Schwat Realty, LLC to have the Court appoint a custodian (the “Custodian Action”). Plaintiff sought the appointment of a custodian pursuant to Section 226(a)(1) of the Delaware General Corporation Law to break the stockholder vote deadlock between her and Steven Schwat and to exercise oversight and managerial powers over the Company. Plaintiff alleged that Steven Schwat prevented her from learning about the Company’s financial affairs and hindered her from being represented on the board of directors of the Company. Simultaneously, Steven Schwat obtained an independent valuation of the Company and ultimately the Company sold unissued shares representing one-third of the Company’s equity to Peter Bonnell, a company executive and member of the board of directors, at a purchase price of $41,289.67 based on the valuation report.
The Plaintiff filed a second action on August 22, 2018, individually and derivatively on behalf of the Company, to invalidate the stock sale (the “Cancellation Action”). Although the stock sale effectively broke the voting deadlock, the Plaintiff argued that in the event the stock sale was cancelled by the Court, the Court should then appoint a custodian. The Cancellation Action was consolidated with the Custodian Action and a trial took place in April of 2019 and the Court held post-trial arguments in October of 2019.
The Court determined that a majority of the board of directors that approved the stock sale was interested in or lacked independence from a party that was interested in the stock sale. The board of directors that unanimously approved the stock sale comprised of Steven Schwat, who sought to retain control of the Company, Peter Bonnell, who was a party to the stock purchase, and Stephen Cox. As such, the burden of proving that the stock sale was fair was shifted to the Defendants under the entire fairness standard of review. The Court determined that the stock sale did not have any material process defects and evaluated whether the sale price was fair. The purchase price was determined by Defendant’s independent appraiser and was based on an income-based approach. Under this approach, the Company’s historical and near term earnings were analyzed to estimate the future free cash flows. The Plaintiff attacked the validity of the stock value appraisal by arguing (i) that the free cash flows in the valuation needed to be adjusted to reflect market profit margin expectations, such as inflated above-market salary expenses and sub-market pricing of the Company’s contracts, (ii) that the application of a specific company risk premium in the cost of equity calculation used to reflect specific-company risk factors was overstated, and (iii) that the contemporaneous valuation of the Company determined by Steven Schwat in his personal capacity was conflicting with the present valuation.
Despite the Plaintiff’s attempt to attack the credibility and accuracy of the appraisal, the Court found that the appraisal was a reliable indication of the fair value of the Company as of the date of the stock sale. The Court recognized that the Plaintiff’s criticism of the valuation had some basis in theory and that there was a level of subjectivity in the calculation of specific company risk premiums. However, the Plaintiff failed to prove an alternative reliable indicator of the fair value of the Company’s stock. The Court concluded that the Defendants met their burden and demonstrated that the stock sale satisfied the entire fairness standard. Accordingly, the Court decided in favor of the Defendants and validated the stock sale. The Court also declined to appoint a custodian.
Co-authored by Marissa Leon