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Snell & Wilmer L.L.P.
July 2006www.swlaw.com
T H E C O R P O R A T Ecommunicator
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It’s My Stock and I’ll Sell If I Want To:WHAT DUTIES ARE OWED BY A CONTROLLING STOCK-HOLDER TO MINORITY STOCKHOLDERS WHEN SELLING A CONTROLLING INTEREST?
By David P. Lewis 602.382.6546 [email protected]
A recent ruling by the Delaware Court of Chancery makes a clear statement
regarding the fiduciary duties that a controlling stockholder owes to minority
stockholders when the controller seeks to sell its stock. Vice Chancellor Leo
E. Strine, Jr.’s opinion enunciates the principle that “[u]nder Delaware law,
a controller remains free to sell its stock at a premium not shared with other
stockholders except in very narrow circumstances.” In reaching its decision,
the Court, although largely in dicta, brings a degree of clarity to the issue of
controlling stockholder duties in the sale context.
Background of the CaseAbraham v. Emerson Radio Corp. involved two public companies, Sport Sup-
ply Group, Inc. (“SSG”), the nation’s largest direct marketer of sporting goods
to bulk buyers, and Emerson Radio Corp. (“Emerson”). Emerson had acquired
a controlling interest in SSG from its founder and CEO in 1996 (who subse-
quently left the company) and, through open market purchases, raised its own-
ership position to 53.2 percent in 1995. In 2003, SSG sought to reverse several
years of disappointing financial results through various strategies, including
voluntarily delisting from Nasdaq in early 2004 to reduce costs. Thereafter
traded on the Pink Sheets, SSG’s stock price ranged from $1 to $3 per share. By
mid-2005, as a result of achieving many of its strategies, the stock reached $3.65
per share.
In July 2005, Emerson announced the sale of its majority stake for cash to Col-
legiate Pacific, Inc. (“Collegiate”) at a price of $6.74 per share, or a premium
of 86 percent. Collegiate, a competitor to SSG, had been founded and was
controlled by SSG’s former founder and CEO. A few months later, Collegiate
BACKGROUND . . . . . . . . . . . . . . . 1
DUTIES OF CONTROLLING
STOCKHOLDER . . . . . . . . . . . . . . . 2
PRACTICAL GUIDANCE . . . . . . . . . 3
CASE UPDATE . . . . . . . . . . . . . . . . 3
OTHER ISSUES . . . . . . . . . . . . . . . . 4
If you have any questions or would
like any assistance regarding
the matters discussed in this
memorandum please contact the
authors, one of the attorneys listed
below or your regular Snell & Wilmer
contact:
David P. Lewis
602.382.6546
John Weston
801.257.1931
Garth Stevens
602.382.6313
Corporate Communicator | July 2006
PAGE 2 | CC
announced that it would merge with SSG, and pay the mi-
nority stockholders an equivalent price in Collegiate stock.
Due to ensuing market conditions that caused Collegiate’s
stock price to drop, however, the merger agreement was
terminated.
The plaintiff’s complaint set forth both a direct, class
claim against Emerson and its officers who ran SSG and
a derivative claim on behalf of SSG against Collegiate
and its officers. Count I alleged that, while Emerson had
a right to sell its stock for a premium, Emerson knew
that Collegiate’s main purpose in purchasing the stake
was to “transfer Sport Supply’s valuable assets to the
use and benefit of Collegiate’s shareholders to the det-
riment of Sport Supply’s shareholders” and therefore
that the premium paid to Emerson should be “equitably
re-distributed” from Emerson to Sport Supply’s public
shareholders, essentially on the theory that Collegiate paid
the premium not for the stock but for the right to misuse
SSG’s assets. Count II, on the other hand, claimed that Col-
legiate, through its purchase of Emerson’s stake, sought
the “unfettered use and enjoyment of Sports Supply’s as-
sets and technologies without fair compensation” to Sport
Supply or its public shareholders. By this course of action,
Count II alleged, Collegiate, as the dominating majority
stockholder, and its officers, as the directors of SSG, had
breached their duty of loyalty by acting to benefit Col-
legiate at the expense of SSG. The court issued its opinion
in the context of a motion to dismiss Count I brought by
Emerson for failure to state a claim upon which relief can
be granted.
The Duties of a Controlling Stockholder Emerson’s motion stated its basic argument that, under
Delaware law and subject to narrow exceptions, a control-
ling stockholder is free to sell its majority stake for a pre-
mium that is not shared with the minority stockholders.
Emerson recited Delaware precedent in making its case
that a controlling stockholder may only be held liable for a
breach of fiduciary duty in this context if:
• it sells its majority stake to a “looter;”
• the looter later injures the corporation; and
• the former controlling stockholder either
(i) knew the buyer was a looter, or (ii) was
aware of circumstances that would alert a rea-
sonably prudent person to a risk that his buyer
was dishonest or in some material respect not
truthful, in which case the controlling stock-
holder incurs a duty “to make such inquiry as
a reasonably prudent person would make, and
generally to exercise care so that others who will
be affected by his actions should not be injured
by the wrongful conduct.”
The court ruled, based on the facts pled, that Emerson did
not know and should not have suspected that Collegiate
was either a looter or was dishonest and had improper
plans for SSG, and it dismissed the complaint.
The more interesting part of the decision, however, came
in the Court’s statement in dicta that it was “dubious
that [Delaware’s] common law of corporations should
recognize a duty of care-based claim against a controlling
stockholder for failing to (in a court’s judgment) exam-
ine the bona fides of a buyer, at least when the corporate
charter contains an exculpatory provision authorized by”
Section 102(b)(7) of the Delaware General Corporation
Law. Section 102(b)(7) provisions are placed in charters for
the benefit of directors and typically read as follows:
“A Director of the Corporation shall not be personally
liable to the Corporation or its stockholders for mon-
etary damages for breach of his or her fiduciary duty as a
Director of the Corporation, except for liability (a) for any
breach of the Director’s duty of loyalty to the Corporation
or its stockholders, (b) for acts or omissions not in good
faith or which involve intentional misconduct or a know-
ing violation of law, (c) under Section 174 of the Delaware
General Corporation Law, or (d) for any transaction from
which the Director derived an improper personal benefit.”
According to the Court, the “premise for contending that
a controlling stockholder owes fiduciary duties in its
capacity as a stockholder is that the controller exerts its
will over the enterprise in the manner of the board itself.”
Thus, in situations where a corporation’s board itself is
Corporate Communicator | July 2006
PAGE 3 | CC
exempt from liability for violations of the duty of care as
a result of a Section 102(b)(7) exculpatory provision in the
corporation’s charter, the court asked “by what logic does
the judiciary extend liability to a controller exercising its
normally unfettered right to sell its shares?” and further
noted that “the unthinking acceptance that a greater class
of claims ought to be open against persons who are ordi-
narily not subject to claims for breach of fiduciary duty
at all – stockholders – than against corporate directors is
inadequate to justify recognizing care-based claims against
sellers of control positions.” Rather, suing stockholders
should have “the duty to show that the controller acted
with scienter and did not simply fail in the due diligence
process.”
Practical Guidance While a fairly simple ruling, the Court’s opinion offers
several practice tips:
• Always include a Section 102(b)(7) exculpatory
provision in your charter. While in dicta only,
the Court’s analysis of how a Section 102(b)(7)
provision may impact the duties of a controlling
stockholder is significant. While typically there
is little or no excuse for failing to include such a
provision in a Delaware corporate charter, it is
not unusual in the context of a transaction to see
corporate charters that do not contain one. Any
company without a Section 102(b)(7) exculpa-
tory provision should promptly seek to amend
its charter so that its directors (and, if applicable,
controlling stockholder) can have the benefits of
such a provision at least going forward.
• Know your buyer. While a controlling stockholder
will not incur liability for an incomplete due
diligence process regarding the buyer of its
majority stake, where the buyer’s plans for the
controlled company amount to nothing more
than the general corporate strategy of seeking
synergies, controlling stockholders should be
aware that they are not immune from liability.
Duty of care claims may stick in situations
where the controlling stockholder knows that
its stake is being sought by a “looter” or where
it is aware that the buyer is dishonest and may
injure the remaining stockholders.
Case UpdateAs a side note, on July 14, 2006, a second lawsuit was filed
regarding the Collegiate/Emerson/SSG transactions seek-
ing damages for breaches of fiduciary duty by Collegiate
and by past and present directors and officers of SSG. This
suit, filed by investment firms purporting to be significant
minority stockholders of SSG, alleges that the individual
director defendants, motivated by various conflicts of in-
terest, breached their fiduciary duties to SSG’s sharehold-
ers by improperly diverting Collegiate’s initial interest in a
merger transaction with SSG, which would have benefited
all SSG stockholders, toward the separate stock-purchase
transaction that benefited only Emerson. The complaint
further alleges that Collegiate knowingly aided and abet-
ted these breaches of fiduciary duty in order to obtain con-
trol of SSG and that, as a result of defendants’ breaches,
SSG shareholders, instead of benefiting from the premium
transaction for all of SSG that Collegiate had originally
desired, were denied their right to participate in this trans-
action. This suit is pending.
* * * *
Corporate Communicator | July 2006
PAGE 4 | CC
On June 20, 2006, the Federal Trade Commission (FTC)
and the Department of Justice’s Antitrust Division an-
nounced that they are implementing an electronic filing
system that allows merging parties to submit via the
Internet premerger notification filings required by the
Hart-Scott-Rodino (“HSR”) Act.
The HSR Act and HSR Rules require the parties to certain
mergers and acquisitions to file Notification and Report
Forms (Forms) with the FTC and the Antitrust Division in
advance of those transactions to enable the enforcement
agencies to determine whether a proposed merger or
acquisition may violate the antitrust laws if consummated
and, when appropriate, to seek a preliminary injunction
in federal court to prevent consummation. Until now,
parties have been required to submit to both the FTC and
the Antitrust Division paper copies of their Forms and
documentary attachments (with the exception of certain
documents, such as SEC filings, that can be provided via
internet links). Under the new system, an HSR filer will
have the option to
• complete and submit the Forms and all attach-
ments in hard copy;
• complete the electronic version of the Forms and
submit the Forms and all attachments electroni-
cally; or
• complete the electronic version of the Forms
and submit it electronically while submitting all
documentary attachments in paper copy.
Due to the highly confident nature of HSR filings, FTC
and Antitrust Division officials noted that every step of
the electronic filing process has been designed to ensure
the confidentiality and security of submitted information,
including requiring a valid electronic signature before sub-
mission of the package and encrypting the signed pack-
age, providing for the secure transmission of the package
over the Internet to a secure FTC server, and employing
multiple security measures once an electronic filing is
received.
Delaware Adopts Majority Voting AmendmentSection 216 of the Delaware General Corporation Law pro-
vides that, absent anything to the contrary in a company’s
charter or bylaws, directors are elected at stockholder
meetings by a plurality of the shares present in person or
by proxy and entitled to vote on the election of directors.
The Delaware Legislature recently adopted two amend-
ments, effective August 1, 2006, that impact director elec-
tions:
• Section 216 was amended to prohibit a board of
directors from amending or repealing a stock-
holder-adopted bylaw that overrides Section
216 and prescribes a specific voting percentage
(such as a majority) for the election of directors;
and
• Section 141(b) was amended to allow direc-
tor resignations to be made effective upon the
happening of a future event or events (such as
the failure to be elected by a majority vote, even
where legally the director only needed a plural-
ity vote) and to provide that such resignations
may be made irrevocable.
Other Issues FEDERAL TRADE COMMISSION AND DEPARTMENT OF JUSTICE TO ALLOW ELECTRONIC SUBMISSION OF HSR FILINGS
Corporate Communicator | July 2006
PAGE 5 | CC
These amendments exhibit the continuing momentum
of the majority vote movement and are expected to lead
to further shareholder pressure on companies to adopt
majority voting bylaws.
Update on the Disney CaseIn our September 2005 Corporate Communicator, we
discussed and analyzed the Delaware Court of Chancery’s
opinion in In re The Walt Disney Company Derivative Liti-
gation, Consol. C.A. No. 15452 (August 9, 2005) (Chandler,
C.). In that case, which dealt with fiduciary duty claims
relating to the Disney board’s approval of a substantial
payout to Michael Ovitz following his short tenure as
President of the company, the court, while critical of the
board, held that each of Disney’s directors fulfilled his or
her fiduciary duties of care and good faith. This decision
was appealed.
On June 8, 2006, the Supreme Court of the State of Dela-
ware affirmed the lower court’s determination that the
Disney directors did not breach their fiduciary duties
either with respect to the hiring and termination of Mr.
Ovitz, or in connection with his termination compensation
package. The court concluded that:
“The Court of Chancery correctly determined that the
decisions of the Disney defendants to approve the [Ovitz
employment agreement], to hire Ovitz as President, and
then to terminate him on a [non-fault] basis, were pro-
tected business judgments, made without any violations
of fiduciary duty. Having so concluded, it is unnecessary
for the Court to reach the appellants’ contention that the
Disney defendants were required to prove that the pay-
ment of the [non-fault termination] severance to Ovitz was
entirely fair.”
In addition, the Court found that the non-fault termination
provisions of the employment agreement did not consti-
tute waste because there was a rational business purpose
for them, namely, that they were an inducement to Ovitz
to leave his lucrative private company to join the public
Disney company.
Corporate Communicator | July 2006
PAGE 6 | CC
D E N V E R L A S V E G A S O R A N G E C O U N T Y P H O E N I X S A L T L A K E C I T Y T U C S O N
Character comes through.®
©2006 All rights reserved. The purpose of this newsletter is to provide our readers with information on current topics of general interest and nothing herein
shall be construed to create, offer, or memorialize the existence of an attorney-client relationship. The articles should not be considered legal advice or opinion, because
their content may not apply to the specific facts of a particular matter. Please contact a Snell & Wilmer attorney with any questions.
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