Garfield v. BlackRock Mortgage Ventures, LLC, C.A. No. 2018-0917-KSJM (Del. Ch. Dec. 20, 2019) (McCormick, V.C.)
In this memorandum opinion, the Court of Chancery denied a motion to dismiss a stockholder’s challenge to the fairness of a reorganization from an Up-C structure to a simple corporate form. The Court found that Corwin was inapplicable because the complaint supported a reasonably conceivable inference that two large stockholders constituted a control group that stood to benefit from the reorganization and further found that the complaint stated a claim under the entire fairness standard.
Under the Up-C structure, PennyMac, Inc. (“PennyMac”) sat above its operating subsidiary, PennyMac, LLC (the “LLC”). In connection with its initial public offering, PennyMac issued Class A common stock to the new public stockholders, which owned 100% of the economic rights but only 15% of the voting rights in PennyMac. PennyMac also issued non-economic Class B common stock to the existing unitholders of the LLC (the “LLC Unitholders”), including PennyMac management, BlackRock, Inc. (“BlackRock”) and Highfields Capital Management (“HC Partners”), which controlled the remaining 85% of the voting rights in PennyMac. The LLC Unitholders continued to derive their economic benefits solely from their LLC units. The Up-C structure was designed in part to allow the LLC Unitholders to more easily realize tax benefits, but these benefits did not materialize due to changes in federal tax laws and in PennyMac’s business. Consequently, at the suggestion of PennyMac’s CEO, the PennyMac board instructed management to discuss reorganization options with the Class B stockholders. The reorganization was designed to allow the LLC Unitholders to exchange their LLC units for PennyMac Class A common stock in a tax-free exchange and receive long-term capital gains treatment on future sales of such stock. The PennyMac board eventually established a special committee to evaluate the reorganization. The special committee recommended approval of the reorganization to the full board, which the board subsequently approved. After the board’s initial approval, HC Partners and BlackRock sought, and the board approved, a new provision providing that the consent of HC Partners and BlackRock was required to terminate the reorganization prior to the effective date. Approval of the reorganization required a majority vote of the PennyMac stockholders. The reorganization was not conditioned on majority-of-the-minority approval.
Following the stockholder approval and closing of the reorganization, a Class A stockholder brought breach of fiduciary duty claims against BlackRock, HC Partners and PennyMac directors who did not serve on the special committee, each of whom owned more LLC units than shares of Class A common stock. The plaintiff argued that the reorganization created benefits for the defendants who held units in the LLC, but not for the stockholders who held Class A common stock in PennyMac. The defendants moved to dismiss, arguing that they should obtain the benefit of the business judgment rule under Corwin because a majority of disinterested stockholders approved the transaction.
The Court of Chancery concluded that Corwin was inapplicable because it was reasonably conceivable that BlackRock and HC Partners formed a control group that exercised effective control over PennyMac in connection with the reorganization, rendering entire fairness the proper standard of review. In finding a reasonable inference of at least transaction-specific control, the Court highlighted that BlackRock’s and HC Partners’ approval of the reorganization was necessary, due to their aggregate 46.1% voting control and the unilateral right of each under the LLC’s operating agreement to block the reorganization, and that BlackRock and HC Partners collectively had the right to appoint four out of the eleven PennyMac directors. Applying the “legally significant connection” standard, the Court also determined that, at the pleading stage, BlackRock and HC Partners may be treated as a group. In so holding, the Court cited the plaintiff’s allegations that the interests of BlackRock and HC Partners were aligned in optimizing the exchange ratio to favor the LLC Unitholders, that BlackRock and HC Partners had historical ties through their ten-year history of co-investment in PennyMac, which was recognized by PennyMac and the group itself in public disclosures, and that BlackRock and HC Partners had transaction-specific ties as shown by their joint meetings, preferential review, exclusive weigh-in and collective treatment afforded to them by management as well as their exclusive joint consent right.
Applying the entire fairness standard, the Court next determined that the plaintiff pled sufficient facts to call into question the entire fairness of the reorganization. First, the Court found that the plaintiff met his burden of pleading that the process was unfair by casting doubt on whether the special committee was fully empowered to negotiate at arm’s length. Specifically, the plaintiff highlighted that BlackRock and HC Partners exercised control over the formulation of the reorganization before it was ever presented to the special committee and that the special committee’s authority was limited to making a recommendation to the board, rather than giving final approval or implementing the reorganization. The Court also found that the plaintiff adequately pled an inference of unfair price, concluding it was reasonably conceivable that the alleged defects in the negotiation process infected the reorganization’s exchange ratio.