Frederick Hsu Living Trust v. ODN Holding Corp., C.A. No. 12108-VCL (Apr. 14, 2017) (Laster, V.C.)
In this memorandum opinion, the Court of Chancery upheld claims against most of the directors on the company’s board, the company’s controlling stockholder, and certain of its officers in connection with the company’s redemption of preferred stock held by the controlling stockholder, notwithstanding that the company was contractually obligated to redeem the preferred stock. The Court held that the plaintiff adequately alleged that the defendants acted disloyally by causing the company to engage in a series of transactions and changes to its business plan to maximize the amount of cash available to redeem the controller’s preferred stock.
In 2008, funds sponsored by venture capital firm Oak Hill Capital Partners (“Oak Hill”) purchased shares of Series A Preferred Stock (the “Preferred Stock”) of ODN Holding Corporation (the “Company”). The terms of the Preferred Stock permitted Oak Hill to require the Company to redeem all of the outstanding Preferred Stock after February 12, 2013. Under Delaware law, however, a company cannot lawfully redeem its stock if the company lacks sufficient funds that are legally available for redemption or if the funds used to effect the redemption exceed the company’s “surplus,” i.e., the excess of its net assets over the par value of its issued stock. If the Company lacked the ability to lawfully complete the redemption, the Preferred Stock would have obligated the Company’s board of directors (the “Board”) to take reasonable actions, in good faith and consistent with its fiduciary duties, to generate sufficient funds to complete the redemption as promptly as practicable.
In 2009, Oak Hill purchased enough of the Company’s common stock to gain control of a majority of the Company’s voting power. Then, beginning in 2011, Oak Hill and the Board allegedly caused the Company to undergo a series of transactions and changes to its business plan to deemphasize generating value for the minority stockholders in favor of accumulating cash to redeem Oak Hill’s Preferred Stock. The changes included: (a) replacing the Company’s officers, and granting certain of them bonuses that would trigger if a threshold amount of the Preferred Stock was redeemed; (b) reducing acquisitions; and (c) selling certain of the Company’s business lines.
In August 2012, the Board formed a special committee (the “Special Committee”) comprised of directors Allen Morgan and Scott Jarus to evaluate the Company’s alternatives for raising capital for redemptions and to negotiate with Oak Hill regarding the terms of any redemptions. Oak Hill exercised its redemption right in full on February 13, 2013. The Company executed two redemptions—one for $45 million in March 2013, and another for $40 million in September 2014 (the “Redemptions”)—the combined amount of which was sufficient to trigger the officers’ bonuses.
In 2016, the plaintiff filed suit against Oak Hill, the directors on the Board (the “Director Defendants”), and certain of the Company’s officers (the “Officer Defendants,” and collectively with Oak Hill and the Director Defendants, the “Defendants”). The plaintiff alleged that the Redemptions were not lawful because the Company lacked sufficient surplus and because the Redemptions either left the Company insolvent or at material risk of becoming insolvent. The plaintiff also asserted claims for breach of fiduciary duty against each of the Defendants in connection with their conduct leading to and in connection with the Redemptions. Finally, the plaintiff alleged a claim for waste, an aiding and abetting claim against Oak Hill, and a claim for unjust enrichment against Oak Hill and certain of the Officer Defendants. The defendants moved to dismiss the complaint, and this decision followed.
First, the Court dismissed the plaintiff’s challenge to the lawfulness of the Redemptions. The plaintiff’s claim depended on the assertion that the Company’s obligation to redeem the Preferred Stock constituted a current liability that reduced the Company’s surplus, which theory the Court rejected based on precedent to the contrary. In addition, the Court held that the factual allegations in the complaint did not support a reasonable inference that the Redemptions materially risked leaving the Company insolvent.
Second, the Court upheld the claims for breach of fiduciary duty against each of the Defendants, except for one of the Director Defendants. Regarding the Director Defendants, the Court found that the complaint reasonably suggested that they acted to benefit Oak Hill and that a majority of the Board lacked independence or disinterestedness such that entire fairness review would apply. In particular, three of the Director Defendants were “dual fiduciaries” that simultaneously owed fiduciary duties to Oak Hill and the Company and were thus conflicted between maximizing the value of the Company for its minority stockholders and Oak Hill’s desire to maximize the return on its investment by redeeming as much of the Preferred Stock as possible. Another of the Director Defendants was a highly compensated Oak Hill employee and was interested based on her eligibility for a bonus upon redemption of a certain amount of the Preferred Stock. Regarding another three of the Director Defendants, the Court found that their alleged conduct, taken as a whole, reasonably suggested that they acted disloyally to benefit Oak Hill, particularly given that two of those directors had past business ties to the controller.
In so ruling, the Court held that the Company’s contractual obligation to redeem the Preferred Stock did not absolve the Director Defendants, explaining that they remained obligated to act in the best interests of their fiduciaries in determining whether and how to comply with the Company’s contractual obligations, particularly because the Preferred Stock explicitly provided that the Board was to generate funds for redemptions in a manner consistent with its fiduciary duties. The Court also held that the formation of the Special Committee to negotiate the Redemptions did not affect the standard of review because the controlling stockholder stood on both sides of the transactions, and thus, the protections described in Kahn v. M&F Worldwide Corp., 88 A.3d 635 (Del. 2014) would have been required to restore application of the business judgment rule.
The Court proceeded to evaluate whether each of the nine Director Defendants was entitled to exculpation and determined that all but one of them were not. The Court found that the complaint supported inferences of disloyalty against each of the seven directors that lacked independence or disinterestedness. Another of the directors, the Court found, was not entitled to dismissal because his receipt of a bonus as a result of one of the Redemptions rendered it conceivable that he acted disloyally and also because he was potentially liable as an officer, in which capacity he would not be entitled to exculpation. The Court, however, found that it could not draw an inference of disloyalty against one of the Director Defendants, Kamran Pourzanjani, who resigned shortly after the Board began implementing changes to maximize the value of Oak Hill’s redemption right. The Court accordingly dismissed Pourzanjani from the case.
Regarding the Officer Defendants, the Court found that the controller’s influence over their employment at the Company sufficiently impugned their independence to support a breach of fiduciary duty claim at the pleadings stage. In addition, the Court found that the complaint stated sufficient facts to suggest that several of the Officer Defendants acted self-interestedly by attempting to trigger their bonuses, which were contingent on redeeming a sufficient amount of the Preferred Stock.
Regarding Oak Hill, the Court upheld the breach of fiduciary claim based on Oak Hill’s exercise of control over the Company to maximize the value of its redemption right at the expense of the common stockholders’ investment, explaining that the conduct of Oak Hill’s agents that held director and officer positions at the Company was attributable to Oak Hill.
Finally, the Court dismissed the waste claim but upheld the claims for aiding and abetting and unjust enrichment. The Court dismissed the claim for waste based on the sale of the Company’s business lines because the Company received significant consideration in connection with those transactions. The Court, however, upheld the aiding and abetting claim against Oak Hill despite upholding the claim for breach of fiduciary duty against it. While recognizing that a fiduciary cannot simultaneously be liable for breach of fiduciary duty and aiding and abetting, the Court found that Oak Hill’s alleged conduct satisfied the elements for an aiding and abetting claim and upheld it in the event that Oak Hill later proved that it was not acting in a fiduciary capacity. The Court similarly upheld the unjust enrichment claim as an alternative theory of liability against Oak Hill and certain of the Officer Defendants in the event any of them had meritorious defenses to the breach of fiduciary duty claims.