Yes, We Have no Estoppel: Chancery Court Rules Derivative, Dismisses Diluted Stockholders' Ex-Texas Merger-Related Claims
In Sheldon v. Pinto Technology Ventures, C.A. No. 2017-0838-MTZ (Del. Ch. Jan. 25, 2019), the Delaware Court of Chancery in a Memorandum Opinion granted a motion to dismiss breach of fiduciary duty claims and other allegations brought by the founder and an early stockholder (“Plaintiffs”) of non-party IDEV Technologies, Inc., a Delaware corporation (“IDEV”). The Court found that Plaintiffs’ primary claims were derivative, rejecting Plaintiffs’ assertion that Defendants were judicially estopped by a Texas state court ruling from arguing for that characterization of the claims, and dismissed the complaint for failure to comply with Chancery Court Rule 23.1’s derivative claims demand or demand futility pleading requirements.
Plaintiffs claimed that venture capital fund investors in IDEV (the “Venture Capital Defendants”) and certain individual IDEV directors (“Defendants”), acted as a controlling shareholder group and improperly used their dominion and control of the IDEV board of directors (“IDEV Board”) to complete a financing and reverse stock split transaction that severely diluted the ownership of IDEV minority common stockholders (the “Financing”), reducing consideration payable to Plaintiffs in Abbott Laboratories’ subsequent merger acquisition of IDEV.
The Court considered the outcome of Plaintiffs’ prior lawsuit in Texas state court against the Venture Capital Defendants, members of the IDEV Board and IDEV management. After litigating all the way to the Supreme Court of Texas, the Texas court defendants successfully argued that a Delaware forum selection clause in agreements governing disputes related to defendants’ investments in IDEV applied. Thus, the Texas suit was dismissed prior to Plaintiffs’ filing their complaint with the Chancery Court. The Chancery Court held that the Texas decision on the forum selection clause was procedural, had no bearing on whether Plaintiffs’ claims were direct or derivative and therefore did not bar Defendants from taking the position that Plaintiffs’ primary claims were derivative. The Chancery Court noted in its reasoning that the Texas court did not consider the issue of direct/derivative claims at all.
The Chancery Court next determined that Plaintiffs’ primary claims were solely derivative, noting that stockholders’ ownership dilution allegations generally are “classically derivative.” The Court indicated that Plaintiffs’ case should not be tried as direct claims because they did not allege facts sufficient to support an inference that actions to improperly dilute Plaintiffs’ ownership in IDEV common stock shares were taken by a control group of majority stockholders and that the IDEV Board lacked a disinterested and independent majority.
Though the Venture Capital Defendants collectively controlled over 60% of the voting power of the outstanding shares of the Company and were parties to a voting agreement governing selection of the IDEV Board, the Court concluded that they did not constitute a control group. The Court reasoned that the voting agreement did not require the Venture Capital Defendants to pursue the Financing and that the Venture Capital Defendants did not have a “long history of cooperation and coordination” because they had not invested together in any other company.
On this point, the Court factually distinguished as inapplicable Chancery Court precedent holding a control group of majority stockholders existed where two individuals and their affiliated stockholder entities coordinated investments in at least seven different companies over more than twenty years, declared themselves as a group to the SEC and included key stockholders that entered into an agreement to vote for a merger and to negotiate directly with the acquirer. The Court found Plaintiffs’ alleged facts to be more analogous to its prior holding that stockholders did not function as a control group where they owned less than 50% of a company’s stock at the time of a merger and were parties to an investor rights agreement that did not compel a vote on the transaction.
Plaintiffs did not allege in their complaint that the IDEV Board lacked a disinterested and independent majority. This further supported the Court’s holding that Plaintiffs complaint should not be treated as direct claims.
The Court ordered dismissal of Plaintiffs’ primary claims that it concluded were derivative since Plaintiffs failed to make a demand on the IDEV Board and failed to assert demand futility in their Complaint. The Court further held that Plaintiffs’ aiding and abetting claims and unjust enrichment claims were also “necessarily derivative” and therefore were dismissed for the same reasons.
The Court additionally ruled that the Abbott Laboratories/IDEV merger transaction extinguished Plaintiffs’ standing to maintain a derivative suit under the continuous ownership rule, even if Plaintiffs had satisfied Rule 23.1’s demand or demand futility pleading requirements. Under this rule, a derivative claimant must be a stockholder at the time of the alleged wrong and at the commencement of the derivative suit, and must maintain shareholder status throughout the litigation. Plaintiffs ceased to be stockholders of IDEV at closing of the merger, prior to commencing this suit.
Finally, the Court dismissed Plaintiff Sheldon’s claims that Defendants breached fiduciary duties by failing to disclose material facts related to the Financing. Sheldon alleged that disclosure regarding a release of claims provision contained in the stock purchase agreement for the Financing did not explain exactly what claims were being released or why. Sheldon also claimed that a disclosure schedule to the agreement inaccurately presented the value of promissory notes given to IDEV employees in exchange for stock and that certain bonuses provided to these employees from which the notes were repaid were not disclosed.
The Court found that these omitted facts were not material because they were not likely to have significantly altered the “total mix” of information available to a reasonable investor and that the effects of the relevant facts disclosed by IDEV regarding the Financing were obvious, even if it is assumed that Sheldon’s allegations constitute direct claims. Therefore, the Court granted Defendants’ motion and dismissed the Complaint with prejudice.