In Re EZCORP Inc. Consulting Agreement Derivative Litig., No. CV 9962-VCL (Del. Ch. Jan. 25, 2016) (Laster, V.C.)
In this memorandum opinion, the Court of Chancery held that the entire fairness standard of review (as opposed to the more deferential business judgment review) applied to a set of related-party agreements, notwithstanding that an Audit Committee of the board approved the agreements. The Court granted in part and denied in part defendants’ motion to dismiss under Rule 12(b)(6), and denied defendants’ motion to dismiss under Rule 23.1.
Plaintiff, a stockholder of EZCORP Inc. (“EZCORP”), challenged the fairness of three advisory services agreements (the “Challenged Agreements”) between nominal defendant EZCORP and defendant Madison Park LLC (“Madison Park”), an entity affiliated with EZCORP’s controlling stockholder, defendant Phillip Ean Cohen (“Cohen”). Pursuant to the Challenged Agreements, Madison Park agreed to provide certain advisory services to EZCORP in return for a multi-million dollar fee. Such services included business and long-term planning. Among other allegations, plaintiff contended that Cohen improperly used the Challenged Agreements as a means to extract a non-ratable cash return from EZCORP. In addition, the advisory services that Madison Park purportedly provided to EZCORP “were substantially, if not entirely duplicative of the services” EZCORP’s senior management already provided, or were capable of providing, to EZCORP.
Based on the these allegations and allegations detailing a history of related-party service agreements between EZCORP and other Cohen affiliated entities, plaintiff asserted four counts of action: (1) a claim for breach of fiduciary duty against the director defendants (“Count I”); (2) a claim for waste of corporate assets against the director defendants (“Count II”); (3) a claim for aiding and abetting the director defendants in breaching their fiduciary duties against Cohen and two Cohen-affiliated entities (“MS Pawn”) that owned stock in EZCORP (“Count III”); and (4) a claim for unjust enrichment against Cohen and Madison Park (“Count IV”).
Defendants moved to dismiss plaintiff’s complaint pursuant to (i) Rule 12(b)(6) for failure to state a claim upon which relief can be granted, and (ii) Rule 23.1 for failure to plead demand futility. After defendants moved to dismiss, plaintiff voluntarily dismissed the director defendants, except Thomas C. Roberts (“Roberts”), who was one of the directors who approved two of the Challenged Agreements. Thus, the only defendants who remained for purposes of defendants’ motions to dismiss were Cohen, Madison Park, MS Pawn, and Roberts.
Considering first the defendants’ Rule 12(b)(6) motion, the Court analyzed a preliminary procedural issue: whether Cohen and MS Pawn were proper defendants under Count I, given that plaintiff technically did not sue either of them for a breach of fiduciary duty. Citing the U.S. Supreme Court case S. Pac. Co. v. Bogert, 250 U.S. 483 (1919) and a litany of Delaware cases addressing the question of when a controller can be found liable for a breach of fiduciary duty, the Court held that Cohen was a proper defendant for a fiduciary duty-based claim because he wielded control over EZCORP through his ownership in MS Pawn. Likewise, MS Pawn was a proper defendant for such a claim because the MS Pawn entities were the channels through which Cohen controlled EZCORP. The Court concluded that, despite not naming Cohen and MS Pawn in Count I, the factual allegations were sufficient to give rise to a breach of fiduciary duty claim against both and that re-pleading was unnecessary.
Next, the Court considered the applicable standard of review, concluding that it was entire fairness. The Court noted that under Delaware jurisprudence, the entire fairness standard of review is not limited to squeeze-out mergers, but also has been applied to service agreements between a controller or its affiliate and the controlled entity, as well as to situations in which a controller extracted a non-ratable benefit at the expense of the minority shareholders. Defendants cited three Delaware cases that applied the business judgment rule—as opposed to entire fairness—in similar situations: Friedman v. Dolan, 2015 WL 4040806 (Del. Ch. June 30, 2015); In re Tyson Foods, Inc. Consol. S’holder Litig., 919 A.2d 563 (Del. Ch. 2007); and Canal Capital Corp. v. French, 1992 WL 159008 (Del. Ch. July 2, 1992). The Court, after reviewing each, concluded that “it appears to me that the weight of authority calls for applying the entire fairness framework more broadly and that the three cases are not persuasive.”
The Court did not stop there, however. Recognizing that Dolan, Tyson, and Canal all relied on the Supreme Court’s decision in Aronson v. Lewis, 473 A.2d 805 (Del. 1984), the Court engaged in a detailed analysis of whether Aronson was controlling precedent for determining the applicable standard of review here.. In doing so, the Court highlighted a doctrinal tension between Aronson—which defendants relied on for the proposition that the business judgment rule applies to transactions involving compensation or a consulting agreement approved by an independent board or committee and in which a controller receives a non-ratable benefit—and other Supreme Court cases that have applied the entire fairness rule in similar situations. The resulting issue for the Court was whether the same underlying rationale supporting a court’s deference to the board’s business judgment in the demand context (as in Aronson) extends to a determination of the substantive standard of review (as in this case). Ultimately, the Court concluded: “In my view, the subsequent evolution of the law undermines the case for extending Aronson beyond the demand-excusal contest. … I would not use Aronson as a springboard for cutting back on post-Aronson case law governing entire fairness transactions.”
Having determined that the entire fairness standard applied to the Challenged Agreements, the Court denied defendants’ Rule 12(b)(6) motion as to Count I. The Court listed a host of allegations that supported “a reasonable inference that the Challenged Agreements were not entirely fair and represented a means by which Cohen extracted a non-ratable return from EZCORP.” Examples of these allegations included the long history of advisory services agreements between EZCORP and the Cohen-affiliated entities; the magnitude of the payments made to Madison Park each year, which were comparable to what EZCORP might have paid out as dividends; and the duplication of services Madison Park agreed to provide and the capabilities and expertise of EZCORP’s senior management. Furthermore, the Court concluded, the Audit Committee’s involvement did not defeat plaintiff’s breach of fiduciary duty claim, because “[w]hen a transaction involving self-dealing by a controlling shareholder is challenged, unless the corporation deploys both an independent committee and a majority-of-the-minority vote, then the most that the use of the committee can achieve is a shift in the burden of proof.” The Court went on to note that defendants can only achieve this result if the company has an effective committee of independent directors—an inquiry that is “fact-intensive” and cannot be determined on a motion-to-dismiss.
With respect to Count II (the waste claim), the Court also denied defendants’ Rule 12(b)(6) motion to dismiss, finding that it was “possible” that the fees EZCORP paid to Madison Park were so excessive as to amount to waste.
In Count III, plaintiff asserted an aiding and abetting claim against Cohen and MS Pawn. The Court dismissed Count III as to Cohen but not as to MS Pawn. It found that “the proper claim for pursuing Cohen is for breach of his duties as a controller,” not for aiding and abetting. For MS Pawn, the Court stated that while “a breach of fiduciary duty claim provides the more straightforward way of reaching MS Pawn, Delaware authority supports the proposition that the entity through which the ultimate controller exercises control can be sued alternatively as an aider and abetter of the ultimate controller’s breach.” With respect to Count IV (claim for unjust enrichment against Cohen and Madison Park), the Court dismissed that claim, finding that “[t]he unjust enrichment count adds nothing” to Counts I and III.
Finally, the Court considered defendants’ Rule 23.1 motion. It found that a demand was excused because there was a reasonable doubt that six out of the seven directors could exercise independent and disinterested business judgment concerning such a demand. Notably, among other allegations supporting that decision, the Court found that EZCORP’s disclosure that three directors lacked independence under NASDAQ’s listing standards was a “helpful fact” and “reinforce[d]” plaintiff’s allegations against the directors’ independence. Furthermore, as it related to Roberts, the Court found there was reasonable doubt that Roberts could impartially consider demand because he: (i) personally participated in the approval process of the Challenged Agreements; (ii) was brought out of retirement and reappointed to the board by Cohen after Cohen terminated three members of the board who disagreed with him; and (iii) was affected by Cohen’s willingness to take retributive action against the board—a fact the Court found “has legal significance.” Thus, considering the allegations as a whole, the Court concluded demand would be futile and thus denied the Rule 23.1 motion to dismiss.