Chancery Court Dismisses Derivative Breach of Fiduciary Duty Claims as Improperly Pled and the Requests for Declaratory Judgment as Not Ripe

Oct 14 2016

In Chester County Employees’ Retirement Fund v. New Residential Investment Corp., No. 11058-VCMR (Del. Ch. Oct. 7, 2016), the Court of Chancery granted the motion to dismiss brought by defendants (the members of the board of directors of New Residential Corp. (“New Residential”), its manager, the manager’s owner, and its controlling stockholder: (i) for an improperly pled derivative claim (with leave to replead) brought against the defendants for breach of fiduciary duty by the plaintiff, a stockholder of New Residential, (ii) for plaintiff’s failure to sufficiently plead futility in demanding that the board of New Residential bring the derivative suit, and (iii) as to declaratory judgments sought by plaintiff with respect to the Defendants’ liability under certain documents as not being ripe (with leave to replead).

On February 22, 2015, New Residential entered into a merger agreement (the “Initial Merger Agreement”) to acquire the outstanding Home Loan Servicing Solutions, Ltd. (“HLSS”) shares for a total of approximately $1.3 billion. The Initial Merger Agreement was ultimately terminated pursuant to a termination agreement releasing all claims under the Initial Merger Agreement (“Termination Agreement”) as the parties were negotiating an alternative agreement for the purchase of substantially all of the HLSS assets in exchange for cash and shares of New Residential common stock equal to approximately $1,441,200,000. In order to fund the HLSS acquisition, New Residential conducted two public offerings in April and June of 2015. The stock issued to fund the HLSS acquisition increased the New Residential paid-in equity capital account. As a result, the Stock Option Plan authorized New Residential to issue 8.54 million options awards to Fortress Operating Entity I LP (“FOE I”) under the management agreement (entered into with New Residential’s manager FIG LLC (“FIG”) for the management of New Residential (“Management Agreement”)) for raising New Residential equity. Additionally, FIG became entitled to a greater management fee of approximately $6.5 million. The complaint does not specify the increase in fees that resulted from the public offering.

Plaintiff, Chester County Employees’ Retirement Fund (the “Plaintiff”), a minority stockholder of New Residential, brought direct and derivative claims for breach of fiduciary duty against the members of New Residential’s board of directors (the “Board”), FIG, FIG’s owner FOE I, and Fortress Investment Group LLC (“Fortress”), which allegedly controls New Residential, FIG, and FOE I (collectively, the “Defendants”). Plaintiff alleged that certain actions by New Residential made the HLSS even more favorable for Fortress. In addition the claims against the Defendants alleged that New Residential overpaid for HLSS given the risky state of the business and its assumption of certain liabilities. The Plaintiff claimed that this was a direct claim because the equity value and voting power of the Plaintiff’s shares in New Residential were diluted as a result of the HLSS transaction. Defendants claimed that any dilution suffered by the Plaintiff was not individual in nature but was a derivative claim since the transaction was with a third party that allegedly injured the corporation. The Court analyzed recent cases that in certain circumstances permitted dual-natured claims. The Court determined that conducting a Chancery Court Rule 23.1 demand analysis would best harmonize the conflicting case law.

The Court noted that the Plaintiff did not demand that the board of New Residential bring a derivative suit. Under Delaware law, the Plaintiff must plead particularized facts showing that demand of the Board to bring a derivative suit is futile in order to avoid dismissal of a motion to discuss under Chancery Court Rule 23.1. The Supreme Court in Aronson v. Lewis provided a two-part test to show demand futility: (i) “the directors are disinterested and independent” and (ii) “the challenged transaction was otherwise the product of a valid exercise of business judgment.” Under the first prong, the Court concluded that the Plaintiff alleged particularized facts sufficient to create a reasonable doubt as to whether three of the directors were disinterested in the HLSS transactions because of their dual fiduciary positions at Fortress and New Residential. Under the second prong the Court concluded that the Plaintiff failed to adequately allege how the New Residential directors were incentivized to overpay for HLSS in order for the Court to analyze the effects of the challenged transactions. The Court granted Defendants’ motions to dismiss due to failure to properly plead the claims, still allowing the Plaintiff, to replead.

Plaintiff sought a declaratory judgement as to whether the twelfth article of New Residential’s certificate of incorporation limits the fiduciary duties of the Defendants with respect to the conduct challenged in the other claims in this case, whether the Management Agreement does not limit Defendants’ liability with respect to the same conduct, and whether the Termination Agreement did not release the claims of New Residential stockholders against HLSS. The Plaintiff alleged that specific New Residential actions made the HLSS acquisition even more favorable for Fortress, including renegotiating the Management Agreement so that it retroactively changed FIG’s incentive compensation resulting in a $3.3 million increase. Additionally, the Plaintiff alleged that the twelfth article of New Residential’s certificate of incorporation eliminates the fiduciary duties of Fortress affiliates, directors, officers, or employees and eliminates any duty that such Fortress parties may have to present corporate opportunities to New Residential. Delaware courts can hear declaratory judgement actions under 10 Del. C. § 6501 as long as an “actual controversy” exists. The Court granted the Defendants’ motion to dismiss the requests for declaratory judgement as unripe as to the Termination Agreement as it was not addressed in the case, the Management Agreement, and the as-applied challenge to New Residential’s certificate of incorporation with leave to replead; however, the motion to dismiss is denied as to the facial validity of the certificate of incorporation.

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