Can a board of directors intentionally disenfranchise a 50% shareholder to break a deadlock while also acting with sufficient good faith to avoid liability? Can a board’s action be grounded in both equitable and inequitable bases and still pass muster? In certain circumstances, yes, according to Chancellor McCormick, who issued a remarkable opinion this week in Coster v. UIP Companies, Inc., Case No. 2018-0440-KSJM (Del. Ch. May 2, 2022).
The facts in Coster are straightforward. Two 50% shareholders owned UIP, a real estate investment company. One of UIP’s owners died, leaving his 50% ownership stake to his wife, Marion Coster. Coster asked UIP and the other shareholder, Steven Schwat, to buy her shares. Schwat and UIP’s board declined. In turn, Coster called two special meetings to elect directors to vacant UIP board seats. The shareholders were deadlocked. Coster then filed suit seeking the appointment of a custodian to break the deadlock. In response, Schwat and UIP’s board approved the sale of one-third of UIP’s outstanding but unissued shares to a UIP executive.
Coster sued UIP and Schwat, claiming the board’s dilution of her equity constituted per se breaches of fiduciary duty. Everyone agreed that UIP issued the new shares ostensibly to block Coster’s lawsuit seeking a custodian’s appointment.
The Court of Chancery recognized that there were “problematic” and “inequitable” aspects to the UIP board’s decision: by issuing more stock, it eliminated Coster’s ability to block stockholder action and Coster’s ability to leverage those rights. In a vacuum, such a board action would be a breach of fiduciary duty.
But the court concluded that UIP’s “board’s decision did not totally lack a good faith basis.” The court found UIP’s board was also motivated to advance UIP’s best interests:
- UIP rewarded and retained an essential employee by granting him UIP stock;
- UIP implemented a succession plan that its original founders had favored prior to any controversy; and
- UIP mooted Coster’s custodian action to avoid a risk of default under certain of the company’s key contracts.
Because UIP acted — at least in part — in good faith and because the UIP board invoked the best interests of the corporation, the Court of Chancery originally rejected Coster’s claims, concluding UIP’s stock sale satisfied Delaware’s entire fairness standard.
On appeal, the Delaware Supreme Court reversed and instructed the Court of Chancery to evaluate whether the transaction also satisfied the seminal Delaware decisions in Schnell v. Chris-Craft Industries and Blasius Industries v. Atlas Corporation. Specifically, the supreme court asked whether UIP’s stock sale was approved for “inequitable reasons,” “for the primary purpose of disenfranchisement without a compelling justification,” or “to interfere with [Coster’s] voting rights as a 50% shareholder and to entrench themselves in office by thwarting the Custodian Action.” If the Court of Chancery found any of those to be true, “the court need not go any further to find a breach of fiduciary duty.”
The Court of Chancery took up the case again on remand. The court began by noting the challenged transaction already passed the entire fairness standard, in its view “Delaware’s most rigorous review standard.” The court recognized that all board action is “twice tested” in Delaware — first, for legal validity, and second, for “equity.” The court questioned whether board action must now “be tested ‘for equity’ under multiple equitable standards and thus potentially tested thrice (or more).”
First, as to Schnell, the Court of Chancery noted that two “modest” paragraphs in that 1971 decision had “done a lot of work in Delaware jurisprudence.” The court recognized Schnell permits a “court of equity to rectify” board actions taken for so-called “inequitable purposes.” But it also described Schnell as “insufferably vague in the sense that it supplies a judge with no real boundaries or guideposts to invalidate otherwise legal conduct.” The court slogged through five decades of Delaware decisions and concluded that Schnell was only applicable “in the limited scenario wherein the directors have no good faith basis for approving [a] disenfranchising action.”
Second, as to the Blasius standard, the court analyzed whether UIP’s approval of the stock sale was for the “primary purpose of thwarting Coster’s vote to elect directors or reduce her leverage as an equal stockholder,” and, if so, “did the UIP board have a compelling justification for doing so?” As to the first question, the court answered “yes” — UIP issued more stock to break the shareholder deadlock. But as to the second question, the court found UIP could articulate compelling justifications for the disenfranchisement. UIP locked up a valuable executive through the stock sale and prevented a default on several key contracts. In the court’s mind, those were sufficiently compelling justifications to avoid a breach of fiduciary duty.
- Raise your hand if you’ve heard this tune before: 50/50 shareholders deadlock as to the management and direction of a closely held company. The court described that the company’s founders had long discussed contingency and succession planning, but never finalized the documents. UIP’s co-founders’ failure to finalize and execute those plans nearly cratered the company. It undoubtedly cost UIP significant money to defend this case. Prepare for contingencies now before problems arise.
- Acting reasonably and treating people with fairness matters. While not dispositive to the final decision, the court emphasized and described in detail the parties’ back-and-forth efforts to resolve the deadlock. Coster’s buy-out demands were nearly 30 times UIP’s equity value. Schwat and UIP offered Coster “a generous buyout price compared to the value of the Company” and “offered multiple compromise positions.” Schwat and UIP’s board positioned themselves in a positive light by treating Coster fairly pre-suit.
- The court’s decision gives future boards a good roadmap for breaking deadlocks and avoiding a custodian’s appointment. A board can dilute a shareholder’s equity and block a custodianship suit if its actions are sufficiently compelling and in the best interests of the company. Issuing stock to a prized executive is always an available option. Custodianships are terribly disruptive to a company and often trigger default provisions in contracts.
- This decision warrants monitoring. Plaintiff succeeded on her first trip to the Delaware Supreme Court, and she’s likely to try again. The Chancellor’s decision is remarkably frank and showed a level of frustration with the Delaware Supreme Court. Trying to make sense of Delaware law, the court at one point stated, “the struggle is real.” If anything, the decision is an open invitation to the supreme court to provide further guidance on key aspects of Delaware corporate law.