Delaware Court of Chancery Allows Stockholder’s Derivative Claim to Proceed Against Alleged Controlling Stockholder Under Entire Fairness Standard of Review

Sep 04 2019

In Reith v. Lichtenstein et al., C.A. No. 2018-0277-MTZ (Del. Ch. Jun. 28, 2019), the Delaware Court of Chancery, in considering a motion to dismiss, allowed a stockholder’s derivative complaint to proceed against a minority stockholder under the entire fairness standard of review, because the complaint had sufficiently alleged that such minority stockholder, by exercising “actual control” as part of transactions being challenged, was effectively a controlling shareholder and thus owed fiduciary duties.

Beginning 2011, Steel Partners Holdings, L.P. (“Steel Holdings”) began to acquire stock in ModusLink Global Solutions, Inc., which was renamed Steel Connect, Inc. (“Steel Connect” or the “Company”). In early 2013, Steel Holdings and the Company entered into an agreement that permitted Steel Holdings to exercise significant control over the Company’s corporate governance and to purchase additional shares. As a result, Steel Holdings secured the election of two individuals to the Company’s board and made additional purchases of Company stock. By late 2016, Steel Holdings owned the entity responsible for managing Steel Connect, was affiliated with Steel Connect management and board members, and owned approximately 36% of Steel Connect’s stock.

Subsequently, Steel Holdings provided financing to Steel Connect in connection with Steel Connect’s acquisition of IWCO, a data-driven marketing firm. As part of the deal financing, Steel Connect issued additional preferred stock to Steel Holdings. The Company’s board, including through a special committee, approved the transaction as well as separate equity grants to Steel Connect’s executive chairman and new board members (who were each affiliated with Steel Holdings). Through the preferred stock issuance and equity grants combined (the “Challenged Transactions”), Steel Holdings increased its beneficial ownership from approximately 36% to 52% of Steel Connect’s stock.

After having sought books and records related to the Challenged Transactions, Donald Reith, a stockholder of Steel Connect (the “Plaintiff”), filed a complaint in April 2018 with both direct and derivative claims (the “Complaint”). In the Complaint, the Plaintiff alleged that the Challenged Transactions were a pretext for allowing Steel Holdings to gain majority voting control of Steel Connect for inadequate consideration and, therefore, both Steel Holdings as the Company’s alleged controlling stockholder and the Company’s directors breached their respective fiduciary duties. The defendants filed a motion to dismiss, contending, among other things, that demand was required.

In addressing the Plaintiff’s claims, the Court first determined that the Plaintiff had sufficiently alleged that Steel Holdings was a controlling stockholder at the time of the Challenged Transactions. The Court observed that the “allegation that a transaction involves a controlling stockholder on both sides is a serious one because it imposes fiduciary duties on the controlling stockholder and potentially strips directors of the protection of the deferential business judgment rule.” The Court explained that, when a plaintiff rebuts the business judgment presumption, the Court applies the entire fairness standard of review to the challenged action and places the burden on the directors to prove that the action was entirely fair — the so-called entire fairness test. Under controlling precedent, a stockholder may be deemed a controller under Delaware law if such stockholder (1) owns more than 50% of the voting power of a corporation or (2) owns less than 50% of the voting power of the corporation but exercises control over the business affairs of the corporation. Here, the Court found that Steel Holdings was a controlling shareholder of Steel Connect by virtue of the “actual control” test, because, despite owning a minority of shares prior to the Challenged Transactions, Steel Holdings wielded “such formidable voting and managerial power that, as a practical matter, it is no differently situated than if it had majority voting control.” Steel Holdings owned a substantial block of stock prior to the Challenged Transactions (approximately 36%), which was a “large enough block of stock to be the dominant force in any contested election.” Further, Steel Holdings had the ability to appoint Company directors with effective control of the Company’s corporate governance structure and exercised control over Company management. Therefore, the Court found that the Plaintiff had pleaded sufficient facts to demonstrate that, as a controlling stockholder at the time of the Challenged Transactions, Steel Holdings owed appropriate fiduciary duties, which in turn triggered entire fairness review.

Next, the Court held that the Plaintiff’s claims regarding the Challenged Transactions were solely derivative (as opposed to both direct and derivative). The Court found that an exception to the general rule — providing that both direct and derivative claims may be brought in narrow circumstances — did not apply to the Plaintiff’s claims regarding the Challenged Transactions. Relying on more recent precedent, the Court found that the dual-natured direct and derivative claim exception did not apply in this instance, because the preferred stock issuance in question did not dilute the minority’s percentage of common shares. Similarly, the Court also determined that the equity grants claim was solely derivative.

Having found that the Plaintiff’s claims were exclusively derivative, the Court then held that pre-lawsuit demand was excused. According to the Court, the Plaintiff was not first required to have demanded that the Company itself initiate litigation, because the Plaintiff had pleaded facts sufficient to show that demand upon Steel Connect’s directors would have been futile.

Finally, the Court allowed the Plaintiff’s preferred stock and equity grant claims to proceed against the directors affiliated with Steel Holdings. However, the Court dismissed the preferred stock claims against the independent directors composing the special committee, because the Complaint failed to plead a non-exculpated breach of fiduciary duty claim.

Donald Reith v. Warren G. Lichtenstein, et al., and Steel Connect, Inc.