Delaware Supreme Court Holds that Equity Dilution and Expropriation Claims May Only Be Brought Derivatively, Overruling Prior Precedent
In Brookfield Asset Mgmt. v. Rosson, No. 406, 2020, 2021 Del. LEXIS 291 (Del. Sept. 20, 2021), the Delaware Supreme Court held that claims for wrongful equity dilution may be pursued only derivatively on behalf of the corporation and not directly. Brookfield is noteworthy because it overruled Gentile v. Rossette, 906 A.2d 91 (Del. 2006), which previously permitted stockholder plaintiffs to assert direct claims for equity dilution where a controlling stockholder orchestrated a dilutive equity issuance that expropriated both economic value and voting power from the minority stockholders. The Delaware Supreme Court revisited the Gentile rule, in part, because it conflicts with the simple test for determining whether a claim is direct or derivative established in Tooley v. Donaldson, Lufkin & Jenrette, Inc., 845 A.2d 1031 (Del. 2004). Under Tooley, a court must determine whether a claim is direct or derivative based solely upon the answer to the following questions: (1) who suffered the alleged harm (the corporation or the stockholders, individually)?; and (2) who would receive the benefit of any recovery or other remedy (the corporation or the stockholders, individually)? Applying Tooley, the Delaware Supreme Court held that a claim for wrongful equity dilution is clearly derivative irrespective of whether shares were issued to a controlling stockholder as part of the dilutive transaction. In the sixteen years since the Delaware Supreme Court decided Gentile, the decision was subject to a steady drumbeat of criticism and proved difficult to apply, which warranted the Court’s reconsideration of Gentile.
Brookfield concerns a dilutive share issuance by TerraForm Power, Inc. (“TerraForm” or the “Company”), a publicly traded corporation, in favor of its controlling stockholder Brookfield Asset Management, Inc. (“Brookfield”). TerraForm’s Board approved a private placement whereby Brookfield acquired newly issued shares of TerraForm that took its ownership of the Company from 51% to 65.3%. Certain stockholders of TerraForm initiated both direct and derivative proceedings in the Delaware Court of Chancery contending that Brookfield caused TerraForm to issue stock to Brookfield for inadequate consideration which diluted both the financial and voting interest of the minority stockholders. While the litigation was pending, a Brookfield affiliate made a tender offer for all of TerraForm’s public shares, which included the shares owned by the derivative plaintiff and, thus, resulted in the dismissal of the derivative claims.
Defendants moved to dismiss the stockholder plaintiffs’ direct claims, contending that the claims were exclusively derivative. The Court of Chancery denied defendants’ motion. Whereas plaintiffs’ claims were clearly derivative under Tooley, the claims also fell within the exception recognized in Gentile, which recognized the stockholders’ direct standing to assert an equity expropriation claim. The Court of Chancery certified its order denying the motion to dismiss for interlocutory appeal. The Delaware Supreme Court accepted the interlocutory appeal to examine the continued validity of Gentile.
The Delaware Supreme Court overruled Gentile because it conflicted with Tooley and undermined the policies embedded in Tooley promoting clarity and simplicity in the evaluation of whether stockholder claims are direct or derivative. As a preliminary matter, an equity dilution claim, even if styled as an expropriation claim, is necessarily derivative under Tooley because “[t]he alleged economic dilution in the value of the corporation’s stock is the unavoidable result of the reduction in the value of the entire corporate entity, of which each share of equity represents an equal fraction.” In other words, “the economic and voting power dilution that allegedly harmed the stockholders flowed indirectly to them in proportion to, and via, their shares in TerraForm, and thus any remedy should flow to them the same way, derivatively via the corporation.” The Gentile exception was unnecessary because there are other avenues through which stockholders can challenge the fairness of a merger or assert fiduciary claims in change-of-control transactions. See Revlon, Inc. v. MacAndrews & Forbes Hldgs., Inc., 506 A.2d 173, 182 (Del. 1986). The Gentile exception also presented other unsound doctrinal challenges. For example, because Gentile recognized that an expropriation claim was both direct and derivative, it created the potential for a double recovery in the event that the stockholders pursued both direct and derivative claims and failed to establish a principled way to allocate the recovery between the stockholder plaintiffs and corporation. In addition, the Gentile exception improperly focused on the identity of the alleged wrongdoer instead of focusing on the nature of the harm and the identity of the person who would receive the remedy as required under Tooley.
The Brookfield decision brings clarity to an area of law that has engendered significant litigation. By reaffirming the primacy of the Tooley test, the Delaware Supreme Court will ensure that, unless a stockholder plaintiff can meet the heightened pleading standards necessary to assert derivative claims under Delaware law, the boards of directors of Delaware corporations remain in control of claims for wrongful equity dilution. The additional strictures applicable to derivative litigation are likely to play a gate-keeping role. As a result of Brookfield, claims for wrongful equity dilution are likely to be resolved earlier in the litigation.