Delaware Supreme Court Holds That Dilution Claims Against a Controller Are Solely Derivative, Overruling Prior Precedent

On September 20, 2021, the Delaware Supreme Court took the highly unusual step of overruling its prior decision in Gentile v. Rossette. An oft-criticized precedent from 2006, Gentile created an exception allowing minority stockholders to bring both direct and derivative claims in situations where a controlling stockholder allegedly diluted the minority’s financial and voting interests, even though dilution claims were normally considered purely derivative. The Delaware Supreme Court has now held that such claims are solely derivative, not direct, even where a controlling stockholder is involved, thereby limiting the ability of minority stockholders to bring such a dilution claim in the wake of a consummated merger since, following an acquisition of all shares, the minority stockholders typically lose their standing to pursue derivative claims. As the Court noted in its decision, the determination of whether a claim is direct (i.e., belonging to the individual stockholder) or derivative (i.e., belonging to the corporation) may therefore be outcome determinative.

Background

The case—Brookfield Asset Management v. Rosson—arose in the context of a private placement in which Brookfield Asset Management (Brookfield) and its affiliates, who were controlling stockholders of TerraForm Power (TerraForm), increased their ownership interest from 51% to 61.5% by acquiring additional shares of TerraForm stock. Thereafter, minority stockholders brought a derivative and class action suit alleging that Brookfield caused TerraForm to issue its stock in the private placement for inadequate value, diluting both the financial and voting interests of the minority stockholders. Shortly after the case was filed, Brookfield acquired the remainder of TerraForm’s stock.

Brookfield sought to dismiss the action on the grounds that (1) plaintiffs’ dilution claims were exclusively derivative because any harm flowed to the corporation, and (2) plaintiffs no longer had standing to bring derivative claims following the merger. In denying the motion to dismiss, the Court of Chancery agreed with Brookfield that dilution claims were “the quintessence of a claim belonging to an entity” under the test articulated in the Delaware Supreme Court’s seminal decision in Tooley v. Donaldson, Lufkin & Jenrette because both the harm, and any recovery, flowed to the corporation. Nonetheless, the Court of Chancery found that the facts fit into a carve‑out created by Gentile which allowed both direct and derivative claims to be brought in dilution cases involving a controlling stockholder. In so holding, the Court of Chancery noted that the outcome was “unsatisfying,” but it was “not free to decide cases in a way that deviates from binding Supreme Court precedent.” The Court of Chancery granted Brookfield’s application for certification of an interlocutory appeal.

The Delaware Supreme Court Decision

On appeal, the Delaware Supreme Court unanimously reversed the Court of Chancery decision and overruled Gentile:

First, the Court held that the Gentile carve-out conflicted with Tooley’s straightforward two-part test for determining whether a claim was derivative or direct. The Tooley test focuses on (1) who suffered the alleged harm (the corporation or the stockholders individually); and (2) who would receive the benefit of any recovery or other remedy (the corporation or the stockholders individually). To plead a direct claim under Tooley, a stockholder must demonstrate that the harm suffered by the stockholder was independent of any harm to the corporation. Under the Tooley test, dilution claims are derivative because the harm—in this instance issuing shares to a controlling stockholder at an inadequate price—flows to the corporation. Any harm to individual stockholders is only indirect through economic and voting power dilution proportional to their shareholdings (and is not independent of the harm to the corporation). In overruling Gentile, the Delaware Supreme Court noted that, although Gentile acknowledged that the corporation was injured in cases of dilution, it nevertheless incorrectly held that dilution by controlling shareholders created a separate, and direct, claim arising out of that same transaction. The Court also noted that the Gentile carve-out incorrectly focused on the identity of the wrongdoer—the controlling stockholder—rather than the identity of the party suffering the injury as required by Tooley.

Second, the Court noted that the Gentile exception was superfluous. Other legal theories provided stockholders a basis for direct claims to address fiduciary duty violations in the change of control context (such as Revlon claims to maximize value in a transaction). Moreover, Gentile created the potential practical problem of allowing two separate claimants (the corporation and the individual stockholder) to pursue the exact same recovery.

Third, the Court noted that it did not overturn precedent lightly. Rather, over 15 years had passed since the Gentile decision. In that time, “the practical and analytical difficulties courts have encountered in applying [Gentile] reflect fundamental unworkability.”

Conclusion

Although the Gentile decision created only a narrow carve-out for dilution claims involving controlling stockholders, the Delaware Supreme Court’s recent decision overruling Gentile is likely to have a significant impact on how stockholders assert dilution claims in the future. Indeed, in many cases, the Brookfield decision will be outcome determinative where a stockholder loses standing to assert a derivative claim post-merger because it no longer owns an interest in the target company.