Clarity or Confusion: The 2005 Amendment to Section 271 of the Delaware General Corporation Law
Although Delaware courts have recognized the separate corporate existence of parent and subsidiary corporations, the close relationship between those entities sometimes raises questions about the proper application of Delaware law. For example, many practitioners have struggled with how Section 271 of the General Corporation Law of the State of Delaware (“Section 271”), which requires a stockholder vote if a corporation intends to sell, lease or exchange all or substantially all of its assets, should operate in the parent/subsidiary context. In particular, some have questioned whether a vote of a parent corporation’s stockholders should be required in transactions involving a drop down of assets to a subsidiary, or a sale of assets by a subsidiary. Nevertheless, over the years, some practitioners developed a reasoned analysis for determining when a stockholder vote under Section 271 would be required in those circumstances.
That reasoned analysis was challenged when the Court of Chancery issued its decision in Hollinger International, Inc. v. Black. In that lengthy decision, the Court of Chancery rejected an argument that the vote of a parent corporation’s stockholders was not required to approve a sale of assets owned by its indirect, wholly owned, non-Delaware subsidiary. The Court’s apparent willingness to collapse the corporate existence of the parent and subsidiary corporations in Hollinger for purposes of Section 271 prompted many to consider what effect the decision would have on the reasoned analysis many had offered before when addressing dispositions of assets in the parent/subsidiary context.
Following on the heels of the Hollinger decision, the Delaware General Assembly recently amended Section 271 to specifically provide that the assets of a wholly owned and controlled subsidiary will be considered the assets of its parent corporation for purposes of Section 271. While new Section 271(c) clarifies when a stockholder vote is required for certain asset dispositions under Delaware law, the amendment also raises a host of interesting questions.
I. The Understanding of the Law Prior to Hollinger.
Section 271 is a Delaware statutory provision that requires a stockholder vote for any sale, lease or exchange of “all or substantially all” of a corporation’s assets. Section 271(a) provides, in pertinent part, as follows:
- Every corporation may at any meeting of its board of directors or governing body sell, lease or exchange all or substantially all of its property and assets, including its goodwill and its corporate franchises, upon such terms and conditions and for such consideration, which may consist in whole or in part of money or other property, including shares of stock in, and/or other securities of, and other corporation or corporations, as the board of directors of governing body deems expedient and for the best interests of the corporation, when and as authorized by a resolution adopted by the holders of a majority of the outstanding stock of the corporation entitled to vote thereon…., at a meeting duly called upon 20 days notice….
Prior to the amendment to Section 271, it was unclear how Section 271 applied in the parent/subsidiary context. For example, it was not clear if the drop down of a corporation’s assets to a wholly owned subsidiary triggered a stockholder vote under Section 271. In addition, it was not clear whether a vote of a parent corporation’s stockholders would be required to approve a sale by its wholly owned subsidiary of assets that would constitute (on a consolidated basis) all or substantially all of the assets of the parent corporation.
A. Drop Down of Assets by Parent to Subsidiary.
Prior to Section 271(c), the drop down of assets by a parent corporation to its wholly owned subsidiary raised interpretational issues under Section 271 because it was not clear that the parent was disposing of its assets in a manner that should have required a stockholder vote under that statutory provision. On the one hand, one could view a drop down of assets to a wholly owned subsidiary as a non-event for the stockholders of the parent corporation because the parent corporation retains ownership of the assets, albeit indirectly. As evidence of that fact, it is likely that the assets of the subsidiary would be consolidated with the assets of the parent corporation for accounting purposes. In addition, to the extent the assets were transferred to the subsidiary as a capital contribution (and not in exchange for the issuance of additional shares of the subsidiary) one could argue that there was a transfer, but not a sale, lease or exchange, of assets of the parent. Thus, it is arguable that no vote of the parent corporation’s stockholders should be required for that drop down.
On the other hand, Delaware law generally recognizes the separate corporate existence of entities. If the separate corporate existence of parent and subsidiary is recognized, then it might be difficult to conclude that the assets, after the drop down, remain the assets of the parent corporation. If so, then the subsidiary, as a separate corporate entity, should be entitled to dispose of the assets without a vote of the stockholders of the parent corporation. The concern raised by the result is another basis for arguing that a drop down of assets should require a vote of the parent’s stockholders under Section 271.
In view of that tension, it has often been difficult to provide advice on the issue of whether a stockholder vote is required for a drop down of assets. Some practitioners have been able to conclude that no stockholder vote should be required for a drop down of assets under certain circumstances. For example, if the drop down is structured as something other than a sale, lease or exchange of assets, some practitioners have argued that no stockholder vote would be required. Often, that conclusion accompanied advice that any sale of those assets by the subsidiary, at least in the near term, might require a vote of the parent corporation’s stockholders.
B. Sale of Assets by Subsidiary.
Prior to Section 271(c), it also was unclear whether a vote of a parent corporation’s stockholders was required if a wholly owned subsidiary intended to dispose of assets that constituted all or substantially all of the assets of the parent corporation on a consolidated basis. Similar to the drop down issue, the interpretational difficulty existed because it simply was not clear whether the assets of the subsidiary should also be deemed to be assets of the parent corporation. If the assets are deemed to be held by both the parent and its subsidiary, no stockholder vote should be required for a drop down, but a vote should be required for a sale of those assets by the subsidiary. On the other hand, if the assets are deemed to be assets of the subsidiary, but not the assets of the parent corporation, a vote of the parent corporation’s stockholders should be required for a drop down, but not for a sale by the subsidiary of those assets.
Prior to Hollinger, some argued that no vote of a parent corporation’s stockholders would be required for a sale of assets by a subsidiary. As a general matter, that conclusion was based on the assumption that the assets were not dropped down to the subsidiary for the purposes of avoiding a vote under Section 271. Therefore, so long as the assets were either never owned directly by the parent corporation, or had been held at the subsidiary level for a significant period of time, it was possible to conclude that no vote would be required. In addition, the conclusion also was based on facts demonstrating an absence of fraud or any reason to pierce the corporate veil and collapse the corporate existence of the parent and subsidiary corporations.
II. The Hollinger Decision.
In Hollinger, Hollinger International, Inc. (the “Parent”) had entered into an agreement to sell the assets (the “Telegraph Group”) of its indirect, wholly owned subsidiary, Telegraph Group Ltd. (England) (the “Subsidiary”). Among other things, Subsidiary published the Telegraph, a leading newspaper in the United Kingdom in terms of both circulation and journalistic reputation. Hollinger, Inc., an entity indirectly controlled by Conrad Black and the controlling stockholder of Parent, commenced a suit in the Court of Chancery seeking to enjoin the sale on the grounds that the stockholders of Parent had the right to vote on the sale because, although held by a subsidiary, the Telegraph Group constituted all or substantially all of the assets of Parent. Parent argued that the Telegraph Group did not constitute all or substantially all of its assets on a consolidated basis, and, even if it did, that no vote of the stockholders of Parent was necessary because the sale involved assets owned by Subsidiary and not Parent.
The Court refused to decide the matter on the latter “technical statutory defense,” and instead treated the assets of Subsidiary as if such assets were owned directly by Parent. Having decided to treat the assets as those of Parent, the Court ultimately concluded that the Telegraph Group did not constitute all or substantially all of the assets of Parent, and thus no vote of Parent’s stockholders was required.
Contrary to the prior dicta on the issue, the Court in Hollinger expressed skepticism with respect to the technical statutory argument that a vote of the stockholders of Parent was unnecessary under the facts of the case. Without addressing at length the literal language of the statute, the Court decided to treat the Telegraph Group as if it was owned directly by Parent in light of the fact that, “as a matter of obvious reality,” the sale process was directed and controlled by Parent.
In reaching that conclusion, the Court noted that none of the subsidiaries, including the Subsidiary, engaged independent financial or legal advisors. Moreover, all of the directors of the subsidiaries were officers of Parent, and those directors had a role in the sale, in their capacity as directors, only after the terms of the sale were completed. In addition, the terms of the relevant contract evidenced the fact that Parent directed the sale process. Not only was Parent a signatory to the contract, but its legal advisors negotiated the terms of the contract. Pursuant to those terms, Parent agreed to cause Subsidiary to perform its obligations under the contract, guaranteed the payment of any breach of warranty claims brought against Subsidiary by the purchaser, and was entitled to receive payments from claims belonging to its subsidiaries.
With those facts in mind, the Court considered the policy implications of determining whether a vote of the stockholders of Parent was required in such circumstances. The Court noted that the technical statutory argument that a stockholder vote was not required had policy arguments in its favor because that argument “has virtues that accompany all bright-line tests, which are considerable, in that they provide clear guidance to transactional planners and limit litigation.” The Court continued as follows:
That approach also adheres to the director-centered nature of our law, which leaves directors with wide managerial freedom subject to the strictures of equity, including entire fairness review of interested transactions. It is through this centralized management that stockholder wealth is largely created, or so much thinking goes.
However, the Court also found that a conclusion in favor of requiring a stockholder vote in the circumstances had policy arguments in its favor. In particular, the Court noted that accepting the technical statutory argument would render Section 271 “largely hortatory – reduced to an easily side-stepped gesture, but little more, towards the idea that transactions that dispose of substantially all of a corporation’s economic value need stockholders’ assent to become effective.” The Court noted such a conclusion would allow a corporation to sell all of its assets through its subsidiaries, that “would, taken together, result in a de facto liquidation of the firm’s operating assets into a pool of cash, a result akin to a sale of the entire company for cash or liquidation.” The Court reasoned that, although the law recognizes the separate existence of wholly owned subsidiaries for purposes of minimizing liability to third parties and tax liability, it does not necessarily mean that the law should recognize their separate existence for all purposes.
Ultimately, the Court declined to rule on the issue and instead assumed, without deciding, that the Telegraph Group was held directly by Parent. Nevertheless, to most practitioners, the Court’s analysis was read as a strong indication of the Court’s willingness, under the appropriate circumstances, to ignore the legal distinction between parent and subsidiary corporations at least for purposes of analyzing whether a stockholder vote was required under Section 271.
III. The Amendment to Section 271.
Effective August 1, 2005, the Delaware General Assembly amended Section 271 to add a new subparagraph (c). Section 271(c) of the General Corporation Law of the State of Delaware (the “Amendment”) provides as follows:
- (c) For purposes of this section only, the property and assets of the corporation include the property and assets of any subsidiary of the corporation. As used in this subsection, “subsidiary” means any entity wholly owned and controlled, directly or indirectly, by the corporation and includes, without limitation, corporations, partnerships, limited partnerships, limited liability partnerships, limited liability companies, and/or statutory trusts. Notwithstanding subsection (a) of this section, except to the extent the certificate of incorporation otherwise provides, no resolution by stockholders or members shall be required for a sale, lease or exchange of property and assets of the corporation to a subsidiary.
In the synopsis relating to the Amendment, the Delaware General Assembly described the purpose of the amendment as follows:
- Section 271 has been amended to add new subsection (c). The purpose of subsection (c) is to provide that (i) no stockholder vote is required for a sale, lease or exchange of assets to or with a direct or indirect wholly owned and controlled subsidiary, and (ii) the assets of such a subsidiary are to be treated as assets of its ultimate parent for purposes of applying, at the parent level, the requirements set forth in subsection (a). The amendment is not intended to address the application of subsection (a) to a sale, lease or exchange of assets by, or to or with, a subsidiary that is not wholly owned and controlled, directly or indirectly, by the ultimate parent.
As a result of the Amendment, it is now clear under Delaware law that a vote of a parent corporation’s stockholders is not required to authorize the drop down of all or substantially all of the assets of that parent corporation to a wholly owned and controlled subsidiary. The Amendment also makes it clear that a vote of the parent corporation’s stockholders would be required before its wholly owned and controlled subsidiary sells, leases or exchanges assets that (on a consolidated basis) constitute all or substantially all of the assets of the parent corporation.
It is worth noting, however, that the reasoning of Hollinger still applies to an asset sale by a subsidiary that is not wholly owned or controlled. As a result, a vote of the parent corporation’s stockholder might be required if the parent corporation directed and controlled the disposition and the assets constituted all or substantially all of the parent’s assets (on a consolidated basis).
IV. Practical Questions.
Although the Amendment appears to be straightforward, several questions arise when one considers how the Amendment operates in the real world. In order to explore certain of those questions, we consider a hypothetical scenario involving a Delaware corporation named Conglomerate, Inc.
Conglomerate, Inc. (“Conglomerate”) was incorporated in Delaware in 1985 as a simple company engaged in the manufacture of widgets. Since the time of its incorporation, Conglomerate has directly owned all of its widget manufacturing assets. As luck would have it, widgets became a highly valuable product during the late 1980s and, bolstered by an optimistic future outlook, Conglomerate became a public company in 1990.
As Conglomerate grew in size, it began to seek to diversify its operations. In its search for new opportunities, Conglomerate learned of a Romanian company named Grommet Co. (“GrommetCo”) that manufactured grommets. Realizing the growth potential in the grommet manufacturing industry, Conglomerate purchased all of the shares of stock held by the stockholders of GrommetCo. As a result of the stock purchase, GrommetCo became a wholly owned subsidiary of Conglomerate in 1995. Although GrommetCo has tremendous growth potential, the widget manufacturing business remains the core asset of Conglomerate and currently constitutes more than 75% of Conglomerate’s total income, profit and assets (on a fair market value basis).
On August 1, 2005, Conglomerate decided to drop down its widget manufacturing assets into WidgetCo, a newly-incorporated, wholly owned subsidiary. On August 2, 2005, a buyer approached GrommetCo’s board and expressed an interest in acquiring that business. In connection therewith, Conglomerate’s general counsel contacted outside counsel and has asked what approvals were necessary to drop the assets down to WidgetCo and to effect a sale of GrommetCo.
A. Is a Stockholder Vote Required for the Drop Down?
Although more due diligence would be required to reach a definitive conclusion, it is likely that the widget assets would constitute all or substantially all of the assets of Conglomerate. Nevertheless, the Amendment now makes it possible for a Delaware practitioner to conclude that no vote of Conglomerate’s stockholders is necessary to drop down the widget assets into WidgetCo.
B. What Does “Control” Mean?
In structuring the drop down, the sole ownership requirement is easily satisfied. A more difficult issue arises when one considers whether Conglomerate will control WidgetCo. The Amendment defines a “subsidiary” as “any entity wholly owned and controlled, directly or indirectly, by the corporation.” However, the Amendment fails to provide a definition for “control.” One must, therefore, consider whether WidgetCo would be deemed to be controlled by Conglomerate through ownership alone, or whether other facts must be present to demonstrate Conglomerate’s control over WidgetCo.
Delaware case law does not provide a fixed legal meaning for concept of “control.” Rather, “its definition varies according to the context in which it is being considered, e.g., fiduciary responsibility, tort liability, filing consolidated tax returns, sale of control.” In determining how “control” would be interpreted in the Amendment, it is useful to examine other provisions in the General Corporation Law of the State of Delaware that include that term.
For example, the Delaware General Assembly recently amended Section 220 of the General Corporation Law of the State of Delaware (“Section 220”) to provide that a stockholder of a corporation may, in certain circumstances, demand to inspect the books and records of a subsidiary of that corporation. Section 220 defines a subsidiary as “any entity directly or indirectly owned, in whole or in part, by the corporation of which the stockholder is a stockholder and over the affairs of which the corporation directly or indirectly exercises control….” Like the Amendment, Section 220 does not contain a definition of “control.”
The Delaware Supreme Court recently had the opportunity to consider the meaning of “control” in the subsidiary definition set forth in Section 220. In interpreting the meaning of “control” in that definition, the Delaware Supreme Court concluded that a parent will be deemed to control a subsidiary for purposes of the definition if the parent has “the power to control the affairs of [the subsidiary] (as distinguished from actually exercising that power).”
The definition of subsidiary in Section 220, however, is different than the definition in Section 271. In particular, the definition in Section 220 includes less than wholly owned subsidiaries. The need for the concept of “control” and its meaning in that context is, therefore, more clear. Because the definition in the Amendment includes wholly owned subsidiaries, one could argue that “control” must mean something more than merely the power to control through ownership. Otherwise, the word “control” would be mere surplusage. It is possible, therefore, that a Delaware court may construe “control” as requiring a showing of the actual exercise of control over the subsidiary. Until the Delaware courts have an opportunity to address this issue, it is unclear how a Delaware court will construe the concept of “control”.
The interpretational issue concerning the definition of “control” has practical consequences. If Conglomerate does not “control” WidgetCo, a vote of Conglomerate’s stockholders may be required before the assets could be dropped down to WidgetCo. It is, therefore, important for practitioners to consider whether a parent corporation controls its wholly owned subsidiary before dropping assets down to that subsidiary.
C. Should Conglomerate Take Steps to Ensure the Retention of Ownership and Control of the Subsidiary?
In light of the interpretational issues relating to the concept of “control,” one should consider whether Conglomerate’s sole ownership of WidgetCo on the day of the drop down is sufficient, or whether additional steps should be taken to demonstrate Conglomerate’s “control” over WidgetCo. One way to demonstrate Conglomerate’s “control” might be to take steps at the time of the drop down to prevent Conglomerate from losing sole ownership and control of WidgetCo in the future. One could argue that the failure to take steps in advance to prevent the subsequent loss of ownership and control might support a conclusion that Conglomerate did not in fact control WidgetCo on the day of the drop down, and thus a vote of Conglomerate’s stockholders was required for the drop down.
A number of techniques could be employed to ensure that WidgetCo remains wholly owned and controlled by Conglomerate. For example, if WidgetCo issues all of its authorized stock to Conglomerate, then WidgetCo would not be able to issue any additional shares unless it amended its charter to increase the authorized number of shares. Since a charter amendment by WidgetCo would require the approval of Conglomerate (as the sole stockholder of the subsidiary), WidgetCo would not be able to issue shares to a third party without Conglomerate’s consent. As an alternative, WidgetCo’s charter could be drafted so as to require a vote of Conglomerate (as the common stockholder) before the subsidiary could take an action (e.g., the issuance of voting debt or stock options) that would threaten Conglomerate’s sole ownership and control of WidgetCo.
Unless the documents are drafted in this manner, the WidgetCo board of directors, from and after the time of the drop down of assets by Conglomerate, retains the power to cause the subsidiary to no longer be “wholly owned” or “controlled” by Conglomerate. The existence of WidgetCo’s ability, ab initio, raises an interesting interpretational question – can Conglomerate be said to “control” WidgetCo for purposes of Section 271(c) in the absence of specific structure protections in the charter of WidgetCo? If one answers that question “no,” then WidgetCo’s assets should not be deemed to be the assets of Conglomerate for purposes of the Amendment. In that case, the Conglomerate board of directors is left to answer a simple question – was the approval of Conglomerate’s stockholders required under Section 271 to effect the drop down of assets to WidgetCo? This question raises one final problem for the Conglomerate board — since Hollinger suggests that there may be circumstances where a vote of a parent corporation’s stockholder would not be required for a subsequent disposition of assets by the subsidiary (for example, when a parent corporation does not direct or control the disposition), could Conglomerate’s failure to have and maintain control of WidgetCo end up depriving the stockholders of Conglomerate of their right to vote on a future disposition of assets by WidgetCo?
However, while it may be tempting to conclude that the Amendment has opened a Pandora’s Box of legal issues, several countervailing considerations should be raised. First, since it will be the rare case where directors of a wholly owned subsidiary would act to divest the parent of its sole ownership and control of the subsidiary, is it really necessary to incorporate in WidgetCo’s organizational documents the type of structural safeguards suggested above? Indeed, since the directors of a wholly owned subsidiary “are obligated only to manage the affairs of the subsidiary in the best interests of the parent and its shareholders,” would the Delaware courts permit the WidgetCo board of directors to erode Conglomerate’s ownership or control of WidgetCo without the full support of Conglomerate?
In that connection, we note that a recent decision of the Court of Chancery concluded that advance notice must be given to a director, who also either is a controlling stockholder or represents a controlling stockholder, before the board of directors of that corporation can authorize a transaction resulting in the loss of the stockholder’s control over the corporation. Accordingly, even if a board of directors of a subsidiary decides to authorize such a transaction, notice of that intent likely must be given to Conglomerate. Conglomerate, upon receiving notice through its directors, would be able to exercise its control over the subsidiary to remove the directors and replace them with new directors who would not take that action. Ultimately, however, the courts will have to weigh in to determine the meaning of “control” in the Amendment and whether it is necessary for a parent corporation to take steps to ensure that sole ownership and “control” is maintained by a parent corporation.
D. When Acquiring a New Business (GrommetCo), Should Conglomerate Take Steps to Ensure That It Falls Outside Section 271(c)?
Unlike a pure “drop down” transaction (for example, the contribution of assets to WidgetCo), an acquisition of a new business that will be held within a subsidiary poses different questions and, potentially, different opportunities for a parent corporation. The hypothetical scenario set forth above illustrates some of those differences.
GrommetCo (the recently acquired business) currently accounts for only 25% of Conglomerate’s assets. As such, if Conglomerate sold GrommetCo (or if GrommetCo directly sold its assets on its own) that sale would not trigger a stockholder vote because it would not involve a sale of substantially all of Conglomerate’s assets. However, since the grommet business is growing rapidly, it is possible that those assets might one day constitute (on a consolidated basis) all or substantially all of the assets of Conglomerate. Thus, the question may be asked whether Conglomerate should want to “control” its wholly owned subsidiary, GrommetCo, for purposes of Section 271(c). If it does control GrommetCo, then a sale by GrommetCo (once it has grown to the point where it represents substantially all the assets of Conglomerate) will trigger a vote of Conglomerate’s stockholders under Section 271(c). In contrast, if Conglomerate structures GrommetCo so that it is either not wholly owned or not controlled by Conglomerate, then the Amendment no longer applies. In that case, the rationale of Hollinger (discussed above) suggests that GrommetCo may be able to effect the sale of its assets in the future without seeking the approval of Conglomerate’s stockholders, provided that (among other things) Conglomerate does not direct or control the sales process for its subsidiary.
E. Can GrommetCo (or its Assets) Be Sold in the Future Without a Vote Under Section 271(c)?
Another issue raised by the Amendment is the possibility to structure a transaction – with the support of Conglomerate - between GrommetCo and a buyer that does not trigger a stockholder vote under Section 271. As noted above, the Amendment does not address a scenario in which a parent corporation loses sole ownership or control of a subsidiary after a drop down of assets to that subsidiary. So, for example, if one assumes that the GrommetCo charter authorizes the issuance of 1000 shares of Common Stock and that GrommetCo only has 100 shares outstanding (all held by Conglomerate), then the GrommetCo board of directors would be permitted to issue and sell 900 additional shares. Under Delaware law, the issuance of such shares may be accomplished without stockholder approval (in the absence of any charter provision to the contrary). Once the buyer has purchased 90% of GrommetCo’s common stock, the buyer may effect a short form merger with GrommetCo pursuant to Section 253 of the Delaware General Corporation Law without any additional action by the GrommetCo board or the other GrommetCo stockholder (Conglomerate). While one may argue that this approach requires the tacit approval of Conglomerate, it is not clear whether that would be sufficient to trigger a stockholder vote of Conglomerate under the rationale of Hollinger.
In the event that the foregoing structure was unavailable (because of insufficient authorized common stock or because the buyer and GrommetCo did not wish to undertake that approach), a transaction structure still may be available that does not trigger a stockholder vote of Conglomerate’s stockholders. If the buyer agreed to merge GrommetCo with a subsidiary of buyer, then GrommetCo (and Conglomerate) could argue, based on Delaware’s doctrine of independent legal significance, that the only stockholder vote required for the transaction is the vote required by the merger statute (in this case, the vote of Conglomerate, as the stockholder of GrommetCo, but not the vote of Conglomerate’s stockholders).
While one may argue why both of these approaches should, in the right circumstance, avoid a vote under Section 271, it is not clear how a Delaware court would react to such transactional planning. Until the Delaware courts (or legislature) offers more guidance in this area, there remains an appreciable risk that a Delaware court would conclude that both structures trigger a vote of Conglomerate’s stockholders because both require Conglomerate to relinquish its control of the subsidiary (either by failing to remove the subsidiary board before it issues shares to the buyer or by affirmatively supporting the planned sale by voting, as a stockholder of GrommetCo, to approve the merger) in order for the transaction to be effected.
F. How Would a Delaware Court Enforce Section 271 Against a Non-Delaware Subsidiary?
Assuming that the assets of GrommetCo eventually grow to constitute all or substantially all of the assets of Conglomerate, a question arises concerning how (and whether) a Delaware court would be able to enforce Section 271 against that Romanian entity if it chose to issue one share of stock to a third party and then dispose of its assets without a vote of Conglomerate’s stockholders. Although we do not endeavor to answer that question in detail, we note that Conglomerate’s stockholders could seek to enjoin the transaction by filing an action in the Court of Chancery.
If a Delaware court issued an injunction in these circumstances, it is likely that the Court would seek to enforce the injunction by holding Conglomerate responsible if the sale moved forward. In that event, Conglomerate’s willingness (and ability) to prevent GrommetCo from effecting the transaction would be tested. Does Conglomerate have control of GrommetCo and therefore the practical ability to prevent the consummation of the transaction?
On the other hand, if GrommetCo consummates the sale before stockholders of Conglomerate object, then it may be more difficult to fashion an appropriate remedy. It is not clear, for example, how a Delaware court could enforce a judgment to unwind a transaction entered into by a non-Delaware entity. The stockholder plaintiffs might consider bringing a fiduciary duty claim against Conglomerate’s Board of Directors alleging that they breached their fiduciary duties by failing to exercise control over the subsidiary, e.g., by replacing the board of directors of GrommetCo, and prevent the disposition. In that case, however, it is not immediately clear whether such a claim would be framed as a breach of the duty of care or as a breach of the duty of good faith. However, since most Delaware corporations’ directors are exculpated from liabilities for due care violations, such a claim would be subject to a motion to dismiss. Therefore, unless the plaintiff could craft the complaint as a breach of the duty of good faith, the plaintiff may be left with little chance of recovering damages or rescinding the transaction.
The Amendment provides clarity with respect to when a vote of a parent corporation’s stockholders is required in connection with the drop down of assets to, and the sale of assets by, a wholly owned and controlled subsidiary. However, a myriad of questions remains concerning the implications of the Amendment for subsidiaries that are not controlled or wholly owned by a parent corporation. In light of those questions, corporate counsel should exercise caution in advising corporations in this context pending future judicial exploration of these issues.
1 Mark A. Morton is a partner and Michael K. Reilly is an associate in the Wilmington, Delaware law firm of Potter Anderson & Corroon LLP. The views expressed are solely those of the authors and do not necessarily represent the views of the firm or its clients.
2 858 A.2d 342 (Del. Ch.), appeal denied, 871 A.2d 1128 (Del. 2004) (TABLE).
3 The amendment to Section 271 was effective August 1, 2005.
4 8 Del. C. § 271(a).
5 See, Leslie v. Telephonics Office Techs., Inc., C.A. No. 13045, 1993 WL 547188, Allen, C. (Del. Ch. Dec. 30, 1993). Cf. Landgarten v. York Research Corporation, C.A. No. 8417, 1988 WL 7392, at *4, Berger, V.C. (Feb. 3, 1988) (stating in a § 220 action that “[n]ormally, the separate corporate existence of a subsidiary will not be disregarded.... Rather, there must be a showing of fraud or that the subsidiary is the ‘alter ego’ of the parent”); S.B. No. 127, 142d General Assembly, 74 Del. Laws Ch. 84 (2003) (stating in the synopsis that the amendments to Section 220 were “not intended to affect existing legal doctrine that, as a general matter, respects the corporate existence of subsidiaries in relation to liability of stockholders to third parties, personal jurisdiction over subsidiaries of Delaware corporations, and discovery in litigation other than under Section 220”).
6 The view that no vote of the parent corporation’s stockholders should be required was based on two main components: (i) the plain language of Section 271; and (ii) the dicta of various decisions of the Delaware Court of Chancery. In particular, by its express terms, Section 271 applies only to the sale, lease or exchange by a corporation of “its” assets. Accordingly, one could argue that the only stockholder vote required by Section 271 was the vote of the stockholders of the corporation whose assets are being sold. In the parent/subsidiary context, that meant that only the sole stockholder of the subsidiary should vote on an asset sale by the subsidiary. In addition, dicta in certain decisions of the Court of Chancery suggest that in most cases no vote of the parent corporation’s stockholders should be required. See Leslie v. Telephonics Office Techs., Inc., C.A. No. 13045, 1993 WL 547188, Allen, C. (Del. Ch. Dec. 30, 1993) (suggesting that separate corporate identities will not lightly be disregarded in the context of a sale by a subsidiary of its assets and, more specifically, that absent fraud or a showing of facts that would justify piercing the corporate veil, no vote of a parent corporation’s stockholders is required by Section 271 for the sale, lease, or exchange of the assets of a subsidiary, even if such assets constitute all or substantially all of the assets of the parent and its subsidiaries on a consolidated basis); J.P. Griffin Holding Corp. v. Mediatrics, Inc., C.A. No. 4056, 1973 WL 651, Marvel, V.C. (Del. Ch. Jan. 30, 1973) (“[I]n as much as defendant is the record holder of all of the shares of its subsidiary ... and has voted all of said shares in favor of such a sale, the provisions of 8 Del. C. § 271 would appear to have been met.”).
7 Hollinger, 858 A.2d at 348.
8 Id. at 372. The Court reasoned that a ruling on the technical statutory defense would “render § 271 an illusory check on unilateral board power at most public companies.” Id. at 348. While acknowledging that a “technical” statutory defense would “involve a rational reading of § 271,” the Court noted that it did not represent the only possible interpretation of that statute. Id.
9 At that time, the directors of the subsidiaries were brought into a meeting so that they could hear the presentation of Parent’s financial advisor and the final discussion about selling the assets of Subsidiary. After hearing the presentations, the directors of each of the subsidiaries, including Subsidiary, approved the sale at meetings that lasted approximately five minutes each. Id. at 372.
10 Id. at 374.
14 The Court suggests that this distinction may be ignored without harming the utility of a holding company structure: “At first blush, it is not apparent why the distinctive considerations that apply to the relationship between stockholders and corporations within the corporate family cannot be recognized without doing violence to the wealth-creating value of limiting the ability of third parties who deal with wholly owned subsidiaries to seek recourse against parent corporations.” Id. at 375.
15 8 Del. C. § 271.
16 H.B. No. 150, 143rd General Assembly, 75 Del. Laws Ch. 30 (2005) (synopsis).
17 Weinstein Enterprises, Inc. v. Orloff, 870 A.2d 499, 506 (Del. 2005).
19 8 Del. C. § 220.
20 Weinstein, 870 A.2d at 506.
21 Id. at 508. Compare VonFeldt v. Stifel Financial Corp., 714 A.2d 79, 83-85 (Del. 1998) (finding that a director elected to serve on the board of a wholly owned subsidiary is deemed to be "serving at the request of" the parent corporation for purposes of Section 145 of the General Corporation Law of the State of Delaware), with Cochran v. Stifel Financial Corp., C.A. 17350, 2000 WL 286722, at *14, Strine, V.C. (Del. Ch. Mar. 8, 2000) (interpreting Section 145 of the General Corporation Law of the State of Delaware and finding that "the General Assembly took a formalistic approach to the relationship between a parent corporation and the director of a subsidiary the parent elected, and did not assume that corporate parents invariably direct and control the directors of their subsidiaries," and noting that "a showing that the director merely ‘served [at] the request of’ the parent is insufficient under [Section] 145 to prove ‘agency’ status; the director must go farther and demonstrate that he was the parent’s agent under the traditional agency definition"), aff’d in part, rev’d in part, 809 A.2d 555 (Del. 2002).
22 Grimes v. Alteon Inc., 804 A.2d 256, 264 (Del. 2002) (stating that the Delaware Supreme Court “will avoid interpreting terms [in a statute] as mere surplusage”).
23 Section 203 of the General Corporation Law of the State of Delaware also includes a definition of “control’ for purposes of that statutory provision. In particular, “control” is defined as follows:
[T]he possession, directly or indirectly, of the power to direct or cause the direction of the management and policies of a person, whether through the ownership of voting stock, by contract or otherwise. A person who is the owner of 20% or more of the outstanding voting stock of any corporation, partnership, unincorporated association or other entity shall be presumed to have control of such entity, in the absence of proof by a preponderance of the evidence to the contrary; Notwithstanding the foregoing, a presumption of control shall not apply where such person holds voting stock, in good faith and not for the purpose of circumventing this section, as an agent, bank, broker, nominee, custodian or trustee for 1 or more owners who do not individually or as a group have control of such entity.
24 Anadarko Petroleum Corp. v. Panhandle Eastern Corp., 545 A.2d 1171, 1174 (Del. 1988).
25 Adlerstein v. Wertheimer, C.A. No. 19101, 2002 WL 205684, at *9, n.28, Lamb, V.C. (Del. Ch. Jan. 25, 2002) (invalidating a transaction divesting a controlling stockholder, who was also a director, of control of a corporation because the controlling stockholder/director was not given advance notice of the purpose of the meeting and noting that although advance notice of the purpose was not technically required by the bylaws, “when a director either is the controlling stockholder or represents the controlling stockholder, our law takes a different view of the matter where the decision to withhold advance notice is done for the purpose of preventing the controlling stockholder/director from exercising his or her contractual right to put a halt to the other directors’ schemes”).
26 But see, Bacine v. Scharffenberger, C.A. Nos. 7862, 7866, 1984 WL 21128, Brown, C. (Del. Ch. Dec. 11, 1984) (suggesting, but not deciding, that authorization by stockholders of parent corporation would be required under Section 271 to approve merger of wholly owned subsidiary with and into another corporation if parent corporation’s stock in such subsidiary constituted “all or substantially all” of parent’s assets and was converted into another form of property in the merger).
27 Schnell v. Chris-Craft Indus., Inc., 285 A.2d 437, 439 (Del. 1971) (stating that “inequitable action does not become permissible simply because it is legally possible”).
28 In fact, that scenario would closely parallel the circumstances presented in Hollinger, where the plaintiff stockholder sought an injunction against a Delaware parent corporation to prevent the sale of assets by a 6th tier U.K. subsidiary. Hollinger, 858 A.2d at 372.
29 See 8 Del. C. § 102(b)(7).
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