Delaware’s Evolving Equity Dilution Standing Rules
By Timothy R. Dudderar and Justin Morse, Potter Anderson & Corroon
In a recent decision from the Delaware Court of Chancery, Vice Chancellor J. Travis Laster provided what seems to be an important step towards reconciling two strands of Delaware law, addressing the distinction between direct and derivative claims, that have been in subtle conflict for years. That decision, Carsanaro v. Bloodhound Technologies, Inc.,1 has already been recognized as an important development in the law governing the relationship between company founders and venture capitalists.2 The Vice Chancellor held that cashed-out stockholders had standing to bring direct, as opposed to derivative, claims alleging that a group of venture capital funds with majority representation on the Board inequitably diluted plaintiffs’ equity stake before ultimately selling the company. In addition to expanding the breadth of stockholder rights to bring direct actions, Carsanaro is notable as an apparent step toward reconciling the accepted test under Delaware law for distinguishing between direct and derivative claims with one line of cases that has stubbornly stood outside of its ambit. It bears emphasis, however, that Carsanaro is only one step towards such reconciliation, and it remains to be seen whether Delaware law will continue down its path.
‘Tooley’ and Development
Of the Delaware Standard
The standards for distinguishing derivative from direct claims under Delaware law were substantially clarified in the Delaware Supreme Court’s 2004 decision in Tooley v. Donaldson, Lufkin & Jenrette, Inc.3 Prior to Tooley, there existed “no standard test … applied in all cases to determine whether a given claim is derivative or direct.” 4 Frequently, however, Delaware courts in the pre-Tooley era applied the so-called “special injury” test, according to which a plaintiff could only bring direct claims if it suffered a “special injury,” defined as “a wrong suffered by plaintiff that was not suffered by all stockholders generally or … [a] wrong [that] involves a contractual right of the stockholders, such as the right to vote.” 5 In Tooley, the Delaware Supreme Court disapproved of the special injury test, together with the related “concept that a claim is necessarily derivative if it affects all stockholders equally.” 6 Rather than looking to whether a plaintiff could plead a special injury, the Delaware Supreme Court in Tooley ruled that the classification of claims as direct or derivative “must turn solely on the following questions: (1) who suffered the alleged harm … ; and (2) who would receive the benefit of any recovery or other remedy … .” 7
‘Gentile v. Rossette’ and
The Lingering Application
Of the ‘Special Injury’ Test
Although simple on its face, the two-part Tooley test has not brought a complete end to uncertainty, and close calls on the direct/derivative distinction continue to arise. In 2006, the Delaware Supreme Court provided some clarification in Gentile v. Rossette,8 which involved allegations that defendants inequitably diluted—or, in the terminology adopted by Gentile, transferred or expropriated—stockholders’ economic interest and voting power when a chief executive officer and controlling stockholder received stock from the corporation in exchange for forgiving debts of allegedly lesser value.9 In Gentile, the Delaware Supreme Court ruled that, under certain circumstances, claims for dilution or expropriation may be brought either directly or derivatively. Specifically, the Gentile court held that either type of action may be brought where:
(1) a stockholder having majority or effective control causes the corporation to issue ‘excessive’ shares of its stock in exchange for assets of the controlling stockholder that have a lesser value; and (2) the exchange causes an increase in the percentage of the outstanding shares owned by the controlling stockholder, and a corresponding decrease in the share percentage owned by the public (minority) shareholders.10
In arriving at its decision, the court cited and applied Tooley, which it had issued just two years before. Yet, while acknowledging that Tooley provided the exclusive test for determining whether a claim is derivative or direct, the Delaware Supreme Court also appears to have been influenced by pre-Tooley authority that Tooley itself criticized. First, the Delaware Supreme Court noted in its analysis that claims for “corporate overpayment” (a category it characterized as including expropriation) are typically treated as “exclusively derivative.” 11 In describing the justification for viewing dilution claims as derivative and, importantly, in affirming that such a classification comports with Tooley, the Delaware Supreme Court stated in terms reminiscent of the special injury test:
any dilution in value of the corporation’s stock is merely the unavoidable result (from an accounting standpoint) of the reduction in the value of the entire corporate entity, of which each share of equity represents an equal fraction. In the eyes of the law, such equal “injury” to the shares resulting from a corporate overpayment is not viewed as, or equated with, harm to specific shareholders individually.12
Similarly, in explaining why claims involving expropriation undertaken specifically by a controlling stockholder may be brought directly, the Delaware Supreme Court explained that under such conditions, “the public shareholders are harmed, uniquely and individually, to the same extent that the controlling shareholder is (correspondingly) benefited.” 13 Such statements appear to be indistinguishable from “the concept that a claim is necessarily derivative if it affects all stockholders equally,” 14 of which Tooley disapproved. Despite never using the term “special injury,” then, Gentile relied on the core assumption of the special injury test: that a stockholder may bring a direct action where it is harmed by being treated differently from other stockholders. Thus, it appears that Gentile, likely not intentionally, re-introduced the concept of special injury, at least with respect to a (potentially limited) subset of wrongful dilution claims.
The influence of the special injury test, or at least the reasoning behind it, is also apparent from decisions cited by the Gentile court to justify direct standing, each of which was decided before Tooley, and, more importantly, relied on the special injury test. Although the Delaware Supreme Court most directly relied on Turner v. Bernstein,15 that decision derived its relevant conclusions from another case also cited in Gentile: In re Tri-Star Pictures, Inc.16 Tri-Star, in turn, involved challenges by former stockholders of Tri-Star Pictures, Inc. to transactions through which the Coca-Cola Company exchanged overvalued assets for Tri-Star stock, with the result that Coca-Cola obtained a majority position while the percentage owned by the minority correspondingly decreased. The Delaware Supreme Court in Tri-Star described application of the special injury test as “well settled,” and held based on that test that plaintiffs could bring direct claims because they had suffered harms stemming from loss of economic interest and voting power not suffered by Coca-Cola.17
Although Tri-Star relied on the special injury test, and although Tooley disapproved of that test in the period between Tri-Star and Gentile, the Delaware Supreme Court’s holding in Tri-Star can be traced directly forward in time to Gentile. Notably, Gentile summarized Tri-Star in a way that did not include the words “special injury” but nevertheless preserved the reasoning of that test:
This Court held that because Coca-Cola, as Tri-Star’s largest stockholder, did not suffer a dilution of cash value, of voting power, or of ownership percentage to the same extent and in the same proportion as the minority shareholders, the plaintiffs had suffered an injury that was unique to them individually and that could be remedied in a direct claim … .18
In the years since Gentile was decided, the special injury test (in concept but not by name) has found its way into a number of decisions through reliance on Gentile. Feldman v. Cutaia,19 an opinion discussed in Carsanaro, provides one example.20 In Feldman, the Court of Chancery cited Gentile, along with another pre-Tooley case that applied special injury, to conclude that a claim cannot be direct where the alleged injury “falls upon all shareholders equally and falls only upon the individual shareholder in relation to his proportionate share of stock as a result of the direct injury being done to the corporation.” 21 Like the Delaware Supreme Court in Gentile, the Court of Chancery in Feldman expressed this reasoning in terms of the Tooley analysis, but did not acknowledge its similarity to or the apparent substantial influence of the special injury test. Instead, Feldman seems to have been guided by stare decisis to find an interpretation of Gentile that would not “swallow the general rule that equity dilution claims are solely derivative.” 22
‘Carsanaro’ Begins Reconciliation
As the foregoing suggests, Carsanaro arose against a background of deceptively unsettled law. Plaintiffs were a group of former common stockholders of defendant Bloodhound Technologies, Inc. (“Bloodhound,” or the “Company”). Plaintiffs primarily alleged that, following successful rounds of financing, venture capitalists gained control of the Company’s board and thereafter caused the Company to enter into a series of additional financings that involved only the venture capital firms (or their board representatives personally) as investors and were highly dilutive to plaintiffs’ collective ownership percentage. Plaintiffs alleged that these financings were concealed from them and it was not until after Bloodhound was sold that plaintiffs discovered that their overall equity ownership had been drastically reduced. Through the lawsuit, plaintiffs sought a greater share of the proceeds from the sale, which they alleged they should have received but for the defendants’ wrongful dilution of their equity ownership.23
Defendants moved for dismissal, arguing, among other things, that the fiduciary duty claims relating to the alleged dilution were derivative in nature and that the merger extinguished plaintiffs’ standing to pursue them.24The Court of Chancery began its analysis with the Tooley test. Under that analysis, the Court of Chancery found that dilution claims like plaintiffs’ can be understood as both derivative and direct.25 According to the Court of Chancery, with respect to the question of who—the corporation or the stockholder individually—suffered the alleged harm, the harmful effects can be felt at both the corporate and stockholder level. While the corporation is harmed because it issued too much stock for too little consideration, the stockholders are also directly harmed because the over-issuance of shares transfers economic value and voting power from the diluted stockholder.26 As to the second Tooley question, the Court of Chancery explained that the claim could be remedied at either the corporate level—by requiring a greater investment in exchange for the issued stock—or, at the stockholder level—“by adjusting the rights of the stock or invalidating a portion of the shares.” 27
Despite having determined that plaintiffs’ wrongful dilution claims could be direct under Tooley, the Court of Chancery continued its analysis. Vice Chancellor Laster recognized that, even though the Tooley test indicated that it can be direct, a claim of this type might nevertheless be restricted by Gentile and its progeny to derivative classification unless the challenged transactions were undertaken at the behest, and inured to the benefit, of a majority or controlling stockholder.28 The Court of Chancery cited Feldman as one decision in which it had “struggled with how to interpret Gentile and its potential to undercut the traditional characterization of stock dilution claims as derivative.” 29 As noted above and by the Court of Chancery in Carsanaro, the Feldman court had declined to permit a stock dilution claim that did not involve a majority stockholder to go forward because to do so “would swallow the general rule that equity dilution claims are solely derivative.” 30 Given that Carsanaro, like Feldman, did not involve a controlling stockholder, Vice Chancellor Laster was thus required to consider what, if any, limitation should be placed on stockholders’ rights to pursue direct claims alleging dilution or expropriation, regardless of the Court of Chancery’s determination of standing under a pure Tooley analysis.
The Vice Chancellor ultimately departed from the limitation applied in cases like Feldman, finding that Delaware Supreme Court precedent does not support such a limitation,31 and also reasoning, importantly, that “the core insight of dual injury applies to non-controller issuances in which insiders participate.” 32 Rather than being limited to transactions involving a majority or controlling stockholder, Vice Chancellor Laster concluded that stock dilution claims could also be direct where a breach of the duty of loyalty is adequately alleged against a majority of the board. On this point, the Court of Chancery stated:
Standing will exist if a controlling stockholder stood on both sides of the transactions. Standing will also exist if the board that effectuated the transaction lacked a disinterested and independent majority. Standing will not exist if there is no reason to infer disloyal expropriation, such as when stock is issued to an unaffiliated third party, as part of an employee compensation plan or when a majority of disinterested and independent directors approves the terms. The expropriation principle operates only when defendant fiduciaries (i) had the ability to use the levers of corporate control to benefit themselves and (ii) took advantage of the opportunity.33
Applying this principle, the Court of Chancery held that the complaint stated a direct claim with respect to the challenged transactions “because each financing challenged in the complaint was a self-interested transaction implicating the duty of loyalty and raising an inference of expropriation.” 34
Questions After ‘Carsanaro’
As discussed at the outset of this article, Vice Chancellor Laster’s Carsanaro decision can be read as a step towards reconciliation of the accepted Tooley test for identifying direct claims with the reasoning of Gentile that permitted claims for expropriation to be pleaded directly despite the traditional view of such claims as exclusively derivative. By focusing not on differential treatment of stockholder groups, but rather on the fiduciary duties at play in the allegedly dilutive transaction—whether owed by a controlling stockholder (as in Gentile) or by directors (as in Carsanaro)—the Vice Chancellor appears to have created a means of analyzing dilution claims that does not rely on the special injury test or its reasoning. In at least one respect, however, Carsanaro leaves room for uncertainty as to how future claims for dilution will be analyzed under Tooley. The Vice Chancellor’s conclusion that such claims may be brought directly only where they implicate a fiduciary’s disloyalty (rather than a mere breach of care) preserves Gentile to the extent that claims that are arguably direct under Tooley may still be pursued only in a derivative action when they do not cross the requisite “line in the sand.” 35 Nonetheless, Carsanaro provides a faithful application of Tooley in this context without having to consider the sometimes inconsistent traditional understanding of claims for equity dilution as exclusively derivative. It is yet to be seen, however, whether Carsanaro marks only a single and not-to-be-extended step, or instead a march towards still broader availability of standing to bring direct claims in cases of alleged equity dilution.
Timothy R. Dudderar is a partner in Potter Anderson & Corroon‘s Corporate Group and focuses his practice on corporate and alternative entity litigation. He can be reached at firstname.lastname@example.org. Justin Morse is an associate in the firm’s Corporate Group. He can be reached at email@example.com.
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