Delaware Supreme Court Holds That Surviving “Entire Fairness” Review is Not Conclusive of a Breach of Fiduciary Duty Claim Where Directors Acted Inequitably
In Coster v. UIP Companies, Inc., No. 49-2020, 2021 WL 2644094 (Del. June 28, 2021), the Delaware Supreme Court reversed a Court of Chancery ruling, No. 2018-0440-KSJM, 2020 WL 429906 (Del. Ch. Jan. 28, 2020) (McCormick, V.C.), that members of a board of directors did not breach their fiduciary duties when they approved a transaction with an “inequitable purpose” because the process and substance of the transaction were “entirely fair” to the aggrieved stockholder. The Court held that even though the board’s action passed Delaware’s rigorous “entire fairness” review, the Court of Chancery should have further considered whether the board acted for inequitable reasons or for the primary purpose of interfering with the stockholder’s statutory or voting rights. As the Supreme Court explained, “inequitable action does not become permissible simply because it is legally possible.” Coster provides an important reminder to board members that ensuring a transaction is “entirely fair” does not necessarily shield directors from liability if the directors acted in bad faith or for the “primary purpose of thwarting” a stockholder’s franchise rights.
In 2007, Wout Coster (“Wout”), Cornelius Bruggen, and Defendant Steven Schwat created UIP Companies, Inc. (“Company” or “UIP”), a real estate investment services company. Each of the three individuals owned one-third stock in the Company. Additionally, UIP had a board of directors composed of Wout, Bruggen, Schwat and two other UIP employees, Peter Bonnell and Stephen Cox. Bruggen ultimately left UIP, leaving a vacant board seat and tendering his stock ownership to Wout and Schwat. In 2015, Wout died and his wife, plaintiff Marion Coster, inherited his stock.
With Wout’s death, Coster and Schwat equally owned UIP, and the board consisted of Schwat, Cox, Bonnell and two vacant seats. Before his death, Wout had begun negotiations to sell his interest in UIP to Schwat. After his death, negotiations between Coster and Schwat continued and then eventually deadlocked. Coster felt Schwat and the board had denied her adequate access to the Company’s financial records. As a result, she called a series of “special meetings” to elect new board members. At each of these meetings, Schwat blocked Coster’s motions to elect a new board.
On June 15, 2018, Coster filed suit against UIP and Schwat, seeking “to appoint a custodian to break the stockholder deadlock” in appointing new board members. Defendants answered, opposing the appointment of a custodian. Subsequently, Schwat, with the board’s unanimous consent, sold one-third of UIP’s stock to Bonnell (“Stock Sale”), thereby lowering Coster’s ownership interest below 50%. Defendants then amended their answer and sought to move for judgment on the pleadings, contending that the custodian action was moot given that Coster was no longer a co-equal owner of UIP with Schwat. Coster sued again, this time asking the court to “cancel the Stock Sale [to Bonnell]” because it “interfered with her voting rights and impeded her statutory right to seek court appointment of a custodian.”
At trial, the Court of Chancery ruled in favor of defendants. Although the court made factual findings that the “Stock Sale was significantly motivated by a desire to moot the Custodian Action” and Defendants “obviously desired to eliminate [Coster]’s ability to block stockholder action,” it “set aside” the factual findings, opting to review the Stock Sale under an entire fairness standard of review. It reasoned that “if the Stock Sale passed entire fairness review, the board’s motives were ‘beside the point.’” The Court of Chancery concluded that the Stock Sale did indeed pass entire fairness review and thus, UIP’s stockholders were no longer deadlocked. The court dismissed the action.
Reviewing the Court of Chancery’s decision de novo, the Delaware Supreme Court held that the Court of Chancery failed to consider the UIP board’s motivation and purpose in issuing the Stock Sale. The Court held that in addition to determining whether a board’s actions were legal, a court also must examine whether the board acted inequitably or intended to interfere with a stockholder’s statutory or voting rights. Under Schnell v. Chris-Craft Industries, Inc., 285 A.2d 437 (Del. 1971), a court must determine whether the board acted for inequitable reasons. If a board acted inequitably, it has breached its fiduciary duty even if its actions were legal. For example, a board acts inequitably when it employs “various legal strategies either to frustrate or completely disenfranchise a shareholder vote” or where it purposefully manipulates “the election machinery to entrench [itself].” The Court went on to hold that even where a board acts equitably, under Blasius Industries, Inc. v. Atlas Corp., 564 A.2d 651 (Del. Ch. 1988), a court must additionally consider whether the board acted for the primary purpose of interfering with a stockholder’s statutory or voting rights. If the board’s primary purpose was to interfere, then the board must “demonstrate a compelling justification” for its action to survive judicial scrutiny. The Court concluded that the Court of Chancery’s decision must be reversed because it did not apply Schnell/Blasius review to the Stock Sale. Although the Court observed that numerous facts supported the contention that the UIP board approved the Stock sale for inequitable reasons, it remanded the case to the Court of Chancery to review all factual findings with a new focus on Schnell/Blasius review.
The Coster decision ties together core principles of Delaware law that Delaware courts will apply when a stockholder alleges a board acted inequitably or interfered with stockholder franchise rights. Board members must remember to act in good faith even when their actions are otherwise legally permissible.
Kevin Murphy also contributed to this article.