Charles Almond as Trustee for the Almond Family 2001 Trust v. Glenhill Advisors LLC, C.A. No. 10477-CB (Del. Ch. Aug. 17, 2018) (Bouchard, C.)
In this post-trial decision, the Court of Chancery relied on Section 205 of the General Corporation Law of the State of Delaware (the “DGCL”) to judicially validate defendants’ ratification of certain defective corporate acts under Section 204 of the DGCL, relating to the implementation of reverse stock splits and the conversion of Series A convertible preferred stock (the “Series A Preferred”) of Design Within Reach, Inc. (the “Company”). The Court also dismissed claims challenging various other transactions occurring prior to the merger of the Company with a third party, finding that such claims were purely derivative in nature (and not partially derivative and partially direct), and that therefore plaintiffs’ standing to bring such claims did not survive the merger.
In July 2014, Herman Miller, Inc. (“Herman Miller”) acquired the Company pursuant to a third-party merger transaction. The merger was the culmination of a turnaround of the Company that began in August 2009 when a group of investment funds known as Glenhill acquired 92.8% of the equity interests in the Company. Glenhill’s equity interests included both common stock and the Series A Preferred. The Series A Preferred were convertible into shares of common stock in certain specified circumstances based on a conversion formula. The Series A Preferred certificate of designation provided for adjustments to such conversion formula in the event of a reverse split of the common stock but not in the event of a reverse split of the Series A Preferred.
In 2010 the board of the Company (the “Board”) decided to implement a 50-1 reverse stock split of both the common stock and the Series A Preferred. The Board recommended, and Glenhill as the majority stockholder approved, the reverse stock split and related transactions, including amending the certificate of incorporation. Following the reverse stock split, Glenhill converted Series A Preferred into common stock in 2013. The short-form merger was accomplished a year later in 2014 after Herman Miller purchased approximately 83% of the Company’s total equity from certain selling shareholders. This permitted Herman Miller to cross the requisite 90% ownership threshold and to effect the merger pursuant to a short-form merger. After the merger, two former stockholders of the Company challenged Herman Miller’s acquisition of the Company, contending that the acquisition was never consummated due to technical mistakes related to the reverse stock split and the conversion transactions that occurred prior to the merger.
Plaintiffs alleged that because the Company failed to complete the reverse stock splits properly, Herman Miller owned less than the requisite 90% of the Company stock required to effectuate a short-form merger. The plaintiffs argued that, as a result, all acts and transactions occurring after the unsuccessful reverse stock split were invalid, including the merger itself. In response, the Board ratified the stock issuances and conversions under Section 204 of the DGCL. The ratification was subsequently approved by the Company’s stockholders acting by written consent. Thereafter, the Company and Herman Miller affirmatively sought relief under Section 205 of the DGCL through a counterclaim to the plaintiffs’ action, requesting validation of the ratification of the alleged defective stock issuances.
The Court first determined that the acts that the Board ratified pursuant to resolutions adopted in accordance with Section 204 of the DGCL were in fact defective corporate acts. The reverse stock split, inadvertently triggered a 98% reduction of the number of shares of the Series A Preferred because the certificate of designation failed to account for an adjustment to the conversion factor of the Series A Preferred. The Court noted that this reduction was a mistake and unintended. Additionally, the 2013 conversions were deficient because the Company was not authorized to issue sufficient shares to cover the conversions. Even though this error was discovered and the Board attempted to correct it with an amendment to the certificate of incorporation, such amendment was defective due to the timing of the authorizations. The Court found that these errors constituted defective corporate acts for purposes of the DGCL. Furthermore, the ratification resolutions appropriately amended the Series A Preferred certificate of designation and the effective date of the certificate of amendment to certificate of incorporation to adequately address such defective corporate acts. The Court noted that Section 205 of the DGCL does not contain a temporal limitation on the Court’s power to validate corporate acts and that due to the technical nature of the defects, the equities overwhelmingly supported correcting these unintended defects.
The Court next evaluated whether it should ratify the defective corporate acts identified in the ratification resolutions. In making such determination, the Court considered the following factors: (a) whether the defective corporate act was originally approved or effectuated with the belief that the approval or effectuation was in compliance with the provisions of the DGCL, the certificate of incorporation or bylaws of the corporation; (b) whether the corporation and board of directors treated the defective corporate act as a valid act or transaction; (c) whether any person will be or was harmed by the ratification or validation of the defective corporate act; (d) whether any person will be harmed by the failure to ratify or validate the defective corporate act; and (e) any other factors or considerations the Court deems just and equitable. The Court found that each of the foregoing factors weighed in favor of judicial validation in the case at hand.
The Court then looked at claims regarding overpayment in connection with the authorization of equity issuance transactions that allegedly unfairly benefitted some or all of the directors of the Board or their affiliates. In the typical corporate overpayment case, a claim against the corporation’s fiduciaries for redress is regarded as exclusively derivative, irrespective of whether the currency or form of overpayment is cash or the corporation’s stock. As a general matter, however, a merger extinguishes a plaintiff’s standing to maintain a derivative suit. As a threshold issue, the Court evaluated whether the merger extinguished the plaintiffs’ standing to maintain a derivative suit in the context of the alleged corporate overpayments. Plaintiffs contended that they had standing to maintain these overpayment claims under the “transactional paradigm” recognized in Gentile v. Rosette, 906 A.2d 91, 99 (Del. 2006), where “a species of corporate overpayment claim” could be both direct and derivative in nature. Gentile, however, has been narrowly interpreted and only applies where (i) there is a controlling stockholder or control group and (ii) the challenged transaction results in an improper transfer of both economic value and voting power from the minority stockholders to the controller. In the current case, Glenhill was already a controlling stockholder at the time of the transactions and did not agree to limit its ability to act in its own self-interest as a controller in some material way. As a result, control resided in Glenhill and not in a “group”. Additionally, Glenhill did not receive any additional percentage of economic and voting power beyond what Glenhill already held in the Company immediately before the challenged transactions. Therefore the Gentile framework did not apply and the plaintiffs’ standing to bring derivative claims for overpayment was extinguished in the merger.
Finally, the Court dismissed a number of other claims for breach of fiduciary duty, equitable fraud and aiding and abetting breaches of fiduciary duties, finding no breaches or equitable fraud.