Reis v. Hazelett Strip-Casting Corp., et al., C.A. No. 3552-VCL (Del. Ch. Jan. 21, 2011) (Laster, V.C.)
In this post-trial decision, Vice Chancellor Laster held that when a controlling stockholder uses a reverse stock split to freeze out minority stockholders without any procedural protections (such as a special committee or a majority-of-the-minority vote), the transaction will be reviewed for entire fairness with the burden of proof on the defendant fiduciary. Here, the controlling stockholder failed to establish that the reverse split was entirely fair as to process and price, and the Court awarded plaintiff damages (less an offset for amounts already paid) plus pre- and post-judgment interest. In fashioning the damages remedy, the Court determined the fair price of the stock at the date of the reverse stock split by applying valuation methodologies commonly applied in determinations of fair value in statutory appraisal proceedings. The Court found that an award in addition to fair value was not called for, because although the reverse split was a self-interested transaction, defendants did not undertake the reverse split to capture the value of opportunities they would otherwise have had to share with the minority stockholders.
From 1956 until Dick Hazelett’s death in 2002, Dick and Bill Hazelett were Hazelett Strip-Casting Corporation’s only stockholders, respectively holding 350 shares and 800 shares. Bill was thus the controlling stockholder, and served as chairman, president, and chief executive officer since the company’s founding. The brothers did not have a voting agreement, and the corporation’s governing documents lacked any provisions limiting Bill’s control as majority stockholder.
When Dick died in 2002, he bequeathed his 350 shares to 169 individuals, consisting primarily of past and present company employees. Plaintiff, one of two executors of Dick’s estate, received two shares of company stock. Bill and his son David (the company’s executive vice president) did not want to open up their family-owned company to outsiders and thus campaigned to acquire the outstanding stock. The other directors, all senior company employees beholden to Bill for their jobs, complied.
When it became clear that the estate would not sell at a price Bill was willing to pay, Bill authorized a reverse stock split that bypassed the executors and achieved the same result as a purchase. The directors acted by unanimous consent to approve and recommend to shareholders the reverse split, whereby every outstanding share would become a 1/400 fractional interest. After the split, Dick’s estate would hold 350/400 of a share, and Bill’s investment vehicle would hold two shares. The board did not set a value for the estate’s interest, but rather resolved that the company would arrange for the disposition of the fractional interest to be held by the estate, and that fair value shall be paid in cash promptly following the corporation’s receipt of a stock valuation study. The reverse split was approved at a special meeting of stockholders attended solely by Bill’s investment vehicle. A valuation study was performed and a check was issued to the estate, but the executors rejected the payment and challenged the validity of the reverse split. Litigation in the Delaware Court of Chancery ensued after the probate court ruled that it did not have jurisdiction to adjudicate the validity of the reverse split under Delaware law.
Section 155(2) of the Delaware General Corporation Law provides that when a corporation undertakes a transaction that results in fractional interests, and opts to compensate stockholders in lieu of issuing fractional shares, the corporation must pay in cash an amount equal to “fair value” of the fractional interests “as of the time when those entitled to receive such fractions are determined.” Delaware precedent, however, holds that Section 155(2) does not contemplate a judicial determination of “fair value” akin to that provided under Section 262; rather, the authority to make the determination of fair value under Section 155(2) is allocated to the corporation, and under Section 141(a), corporate authority is vested in the board of directors. After a discussion of Delaware’s three tiers of scrutiny for evaluating director decision-making (the business judgment rule, enhanced scrutiny, and entire fairness), the Court held that entire fairness was the appropriate standard of review here because the controlling stockholder had caused the reverse split for the purpose of freezing out the minority, and had not employed any procedural protections, such as a special committee or a majority-of-the-minority vote.
As to the first prong of entire fairness review, fair dealing, the Court held that “there was no dealing in this case that could be called ‘fair.’” Among the facts cited by the Court as evidence of an unfair process was the fact that Bill and David offered to purchase the shares held by Dick’s estate for $1,500 per share, a price unilaterally set by Bill without input from anyone else or any valuation analysis; that Bill and David made threats to the effect that the minority stockholders would never receive any dividends; that the company would never pay a higher price for the minority shares; that the Hazelett family would never sell its shares; and that if the estate did not accept the company’s offer, the company might consider offering selected minority stockholders the far lesser price of approximately $990 per share.
As to the fair price component of entire fairness review, the Court observed that “[t]echnically, the defendants did not set any price,” because at the time the reverse split was actually implemented, defendants did not make any effort to determine the “fair value” of the fractional interest, but rather relied on a then-three-year-old valuation study.
In fashioning the appropriate remedy, the Court discussed the scope of remedies available in entire fairness cases as compared to appraisal proceedings, acknowledging the increased breadth of possible remedies in an entire fairness case, but held that the fair value standard embraced by appraisal proceedings is “economically efficient and should be applied consistently to freeze-outs, regardless of form.” The Court found that a remedy in addition to an award of fair value was not appropriate, because although the reverse split was a self-interested transaction, defendants did not undertake the reverse split to capture the value of opportunities they would otherwise have had to share with the minority stockholders. The Court examined the parties’ various valuation analyses, and ultimately used a blended average that afforded 80% weight to capitalized earnings and 20% to book value to arrive at the damages award. The Court offset the award by the amount already paid by defendants, and added pre- and post-judgment interest.