As we have discussed on a number of occasions, the ability to control imposes fiduciary duties of loyalty and care on whoever, or whatever, exercises that control. It is a fundamental principle of business law in many states, including New Jersey and New York, that one sees frequently in closely held businesses.
The decision is significant first because it was handed up by the Delaware Court of Chancery. The decisions of Delaware Chancery judges influence decisions in most other state courts, particularly when there is no statute or decided case directly on point. Second, it provides some clear guidelines on the limits of the exercise of voting control of an entity..
The court held that controlling shareholders exercising voting power in a way that changes the status quo have fiduciary duties not to harm the corporation, either intentionally or through grossly negligent action. Here, there was no breach of fiduciary duty, but the transaction at issue failed to meet the standard of fairness that applies when a controlling majority has an interest in the transaction.
The case, In re Sears Hometown and Outlet Stores, Inc. Stockholder Litigation, involved the minority shares of Sears Hometown and Outlet Stores, Inc., which was in bankruptcy and liquidation procedures.
The Court went on to hold that a subsequent minority buy-out was not entirely fair, but the damage to the minority shareholders was far less than they claimed.
Why the Decision of Controlling Sharheholders Could be Disputed in Sears Bankruptcy Liquidation Value
Eddie Lampert, a controlling stockholder of Sears Hometown and Outlet Stores, Inc., was at the center of the legal dispute over the company’s liquidation plan. Lampert, chairman of Kmart — which now operates only a handful of stores, had engineered the acquisition of Sears by Kmart in 2004.
Sears failed and Lampert acquired its assets through a hedge fund, ESL Investments. The company under Lamerpert operated through two separate entities: “Hometown,” which consistently incurred losses, and “Outlet,” a profitable line of retail stores.
In 2016, the board created a special committee to anticipate a transaction between the company and Lampert. However, no transaction materialized, and in 2018, the board proposed a plan to liquidate Hometown and focus on growing Outlet’s profits. Lampert disagreed with the liquidation plan, arguing that the board underestimated the risks associated with a retail liquidation without bankruptcy protections and risked destroying stockholder value.
In response, Lampert used his power as the majority stockholder to amend the bylaws by written consent, requiring the Hometown liquidation to receive 90% board approval and two votes, a month apart, before taking effect. He also removed two directors, who were members of the special committee and supported the Hometown liquidation, leaving just one director on the special committee.
Lampert’s actions successfully blocked the Hometown liquidation. The board, through the special committee, negotiated a transaction that resulted in Lampert cashing out the remaining minority stockholders.
One of the minority stockholders filed suit against Lampert for breach of his fiduciary duties as a controlling stockholder. The Court found that Lampert did not breach his fiduciary duties when he exercised his voting power to amend the bylaws and remove the two directors, but that the transaction failed to meet the “entirely fair” standard.
The Court noted that a controlling stockholder is not prohibited by law from using its voting power to prevent board action. However, when wielding voting power to “affirmatively change the status quo,” a controller owes a duty of loyalty that forbids the controller from intentionally harming the corporation or minority stockholders, and a duty of care that requires the controller to avoid harm to the corporation or minority through gross negligence.
The Court held that Lampert satisfied the requirements of enhanced scrutiny, finding that his actions were necessary and sufficient to neutralize a perceived threat. This ruling indicates that defensive actions carried out by a controller through its voting power can withstand enhanced scrutiny to the extent that such actions were intended to protect against a perceived threat.
However, the question remains whether a controller’s unilateral exercise of its voting power will always trigger enhanced scrutiny. The Court used broad language in holding the controller’s actions subject to review under enhanced scrutiny, but it was not called upon to address what standard of review should apply when a controller acts without a pending threat to its interests.
The Court ruled that Lampert’s acquisition of shares held by minority stockholders was not entirely fair. The court found that Lampert’s exercise of voting power to prevent the Hometown liquidation was consistent with his fiduciary duties, but the acquisition of remaining shares required review under the more exacting entire fairness standard.The Court was satisfied that neither the timing nor initiation of the transaction raised “fairness issues,” but concerns about how the transaction was negotiated were raised.
The Court distinguished between the Outlet and Hometown segments, determining the fair price by comparing the market-tested price of Outlet and the risk-adjusted liquidation estimate of $98.41 million for Hometown. However, the Court rejected Lampert’s position that the liquidation value should be reduced based on the control premium associated with his ownership, finding that Lampert effectively asked the court to apply an unjustified minority discount.
The court awarded damages of $1.78 per share, totaling approximately $18.3 million for the class of minority shareholders that brought suit.
Who the Entire Fairness Doctrine Applies to
The Court’s opinion is significant for mapping out the contours of the fiduciary duties a controller owes to minority stockholders when exercising its voting power. It states that when simply voting against a proposal that would change the status quo, the controlling stockholder owes no duties.
In evaluating whether the controller’s unilateral action to amend bylaws and remove directors breached his fiduciary duties, the Court applied enhanced scrutiny. Under that standard, the Court concluded that the controlling stockholder had a reasonable, good-faith belief that the liquidation plan was based on overly optimistic estimates of resulting value and would harm stockholders.
However, the Court found the controller liable to minority stockholders because the resulting Hometown acquisition failed the entire fairness test. The Court determined that, even though the remaining member of the Special Committee performed his duties in an exemplary fashion, the controller had limited the negotiating power of the committee by removing two of its three members, rendering the process unfair.
The court held that the transaction had to meet Delaware’s entire fairness test for a transaction in which the controlling shareholder or directs have a direct interest that conflicts with the interests of the transaction. The entire fairness test requires that the controlling party establish both that the price paid in the transaction was fair, and that the process itself was fair.
The Chancer Court held that the price paid by the controller for Hometown did not meet the test, even though Lampert subjectively believed that it did. Accordingly, the transaction as a whole failed the entire fairness test.
The Key Issue: Understanding the Duties of the Controlling Owners or Directors to the Minority
Under Delaware law, the Chancery Court held, when exercising its voting power to change the status quo,the controller cannot cause harm to the corporation or its minority stockholders through intentional, knowing, or grossly negligent conduct. The same is true in most other jurisdictions and it is frequently an element in minority oppression or breach of friduciary duty claims.
The key point here is not so much the application of the specific Delaware test, as an understanding that the ability to control a business entity often creates a greater obligation than to vote the controlling interest of an individual or group of individuals in a way that negatively affects the interests of the minority owners. State laws will vary, but the principle holds generally true.
Majority owners should be aware of their own exposure, and minority owners should be vigilant in protecting their rights.