Delaware Chancery Court Refuses to Dismiss Derivative Action Alleging Breach of Fiduciary Duty, Unjust Enrichment, and Disclosure Related to Equity Grants | Practical Law

Delaware Chancery Court Refuses to Dismiss Derivative Action Alleging Breach of Fiduciary Duty, Unjust Enrichment, and Disclosure Related to Equity Grants | Practical Law

In Reith v. Lichtenstein, the Delaware Chancery Court held that the plaintiff successfully pled, for purposes of surviving a motion to dismiss, that a company's board of directors breached its fiduciary duty to the company by approving sizable equity grants to several directors in violation of the company's equity incentive plan, that several board members and entity defendants were unjustly enriched by the equity grants, and that the board breached its duty of candor by making faulty disclosures when seeking stockholder approval for amendments to the company's incentive award plan in connection with the equity grants.

Delaware Chancery Court Refuses to Dismiss Derivative Action Alleging Breach of Fiduciary Duty, Unjust Enrichment, and Disclosure Related to Equity Grants

by Practical Law Employee Benefits & Executive Compensation
Published on 09 Jul 2019 • USA (National/Federal)
In Reith v. Lichtenstein, the Delaware Chancery Court held that the plaintiff successfully pled, for purposes of surviving a motion to dismiss, that a company's board of directors breached its fiduciary duty to the company by approving sizable equity grants to several directors in violation of the company's equity incentive plan, that several board members and entity defendants were unjustly enriched by the equity grants, and that the board breached its duty of candor by making faulty disclosures when seeking stockholder approval for amendments to the company's incentive award plan in connection with the equity grants.
In the unpublished opinion Reith v. Lichtenstein, the Delaware Chancery Court held that the plaintiff had successfully pled, for purposes of surviving a motion to dismiss, that:
  • A company's board of directors breached its fiduciary duty to the company by approving sizable equity grants to three board members in violation of the company's equity incentive plan.
  • Several board members and entity defendants were unjustly enriched by the equity grants.
  • The director defendants breached their duty of candor by making faulty disclosures in the company's proxy statement when seeking stockholder approval for amendments to the company's incentive award plan in connection with the equity grants.
( (Del. Ch. June 28, 2019).)

Background

In 2011, a holding company, Steel Partners Holdings, L.P. (Steel Holdings), started to acquire stock in a company eventually named Steel Connect, Inc. (the company). In 2013, Steel Holdings entered into a settlement agreement with the company to appoint directors to the company's board and purchase more shares. In the years that followed, Steel Holdings gradually purchased more of the company's stock and eventually started to provide management services to the company.
In August 2017, in an attempt to use the company's net operating loss carryforwards (NOLs) to reduce the company's taxes, the company agreed to acquire a Delaware corporation, IWCO. The company formed a special committee of independent directors (the Special Committee) to discuss how the company would finance its acquisition of IWCO.
On December 15, 2017, the company's board of directors:
  • Approved the acquisition, which was partially financed by a $35 million capital raise through the issuance of preferred stock to Steel Holdings.
  • Added two new board members.
  • Awarded equity grants to the two new directors and the chairman of the board.
The preferred stock and equity grants gave Steel Holdings and its affiliates a greater percentage of beneficial ownership of the company (an increase from approximately 35.62% to approximately 52.3%).
The equity grants provided a total of 5.5 million shares of the company's stock to the three directors. The two new board members received their grants for their current and future services to the company. 4,000,000 shares of the equity grants were vested immediately upon grant, and the remaining 1,500,000 shares vested according to a schedule based on the company's stock price. 1,050,000 shares were subject to stockholder approval due to limits provided in the company's 2010 Incentive Award Plan (2010 Plan).
In March 2018, the company filed its 2017 Schedule 14A proxy statement, in which it sought to amend the 2010 Plan by:
  • Increasing the number of shares available for issuance from five million to eleven million.
  • Eliminating the limit on the number of "Full Value Awards" that could be issued under the 2010 Plan (under the terms of the 2010 Plan, Full Value Awards include any award other than a stock option, stock appreciation right (SAR), or any other award for which the holder pays the intrinsic value as of the grant date).
The 2017 proxy omitted certain key facts regarding the 2010 Plan, including the fact that the 2010 proxy stated that the maximum number of Full Value Awards that could be issued was three million shares. The 2017 proxy stated that the three million limit applied not to all Full Value Awards, but only to those issued under the company's compensation plans prior to the 2010 Plan that were forfeited, lapsed, or settled in cash after the 2010 Plan's effective date, which were recycled for use under the 2010 Plan (the "Recycled Awards"). The 2017 proxy did not make other disclosures regarding the 2010 plan. The 2017 proxy also informed stockholders about the 1,050,000 shares that were subject to stockholder approval, but did not reiterate the previously disclosed details of all of the equity grants.
In April 2018, the plaintiff filed a complaint in Delaware Chancery Court against the defendants, who include several board members as well as several entities involved in this case, alleging that the sale of preferred stock in connection with the acquisition and the equity awards resulted in:
  • Direct and derivative claims for breach of fiduciary duties, including a disclosure claim.
  • Direct and derivative claims against the entity defendants for aiding and abetting those breaches.
  • A breach of fiduciary duty by Steel Holdings as the company's controlling stockholder.
  • The unjust enrichment of the recipients of the preferred stock and equity grants.
(The claims relating to the sale of preferred stock are outside the scope of this update.)
The defendants filed a motion to dismiss the plaintiff's claims under Court of Chancery Rules 12(b)(6) and Rule 23.1.

Outcome

On June 28, 2019, the Chancery Court held, in regard to the plaintiff's equity grant claims, that:
  • Steel Holdings is a controlling stockholder of the company.
  • The plaintiff's claims are solely derivative. The court held that the plaintiff has adequately pled a derivative claim against the Special Committee defendants regarding the equity grants.
  • The aiding and abetting claims were dismissed.
  • Demand is excused regarding the plaintiff's equity grant claims.
  • The plaintiff adequately pled, in regard to the equity grants:
    • a breach of fiduciary duty;
    • an unjust enrichment claim; and
    • a disclosure claim.

Controlling Stockholder

Based on Steel Holding's ownership of the company's stock, and its influence over the company's board of directors and management, the court held that it is reasonably conceivable that Steel Holdings was a controlling company stockholder that exercised actual control over the company's business affairs at the time the company negotiated the IWCO acquisition and the company's board of directors approved the equity grants, and therefore owed a fiduciary duty to the company.

Derivative Claims

Legal challenges based on excessive payments of corporate funds, such as the claims regarding the equity grants for current and future services to the company, are traditionally derivative claims under Delaware law. The Chancery Court held that the plaintiff's claims, including the equity grant claims, are solely derivative claims because any loss caused by the equity grants was experienced by, and any recovery would go to, the company. The court dismissed the plaintiff's direct claims of breach of fiduciary duty.

Demand Excusal

Under Court of Chancery Rule 23.1, before a plaintiff can bring a derivative action, he must either:
  • Make a demand on the board before filing its complaint.
  • Allege with particularity that demand on the board would be futile and therefore the failure to make a demand should be excused.
The plaintiff did not make a demand upon the company's board to bring suit regarding his derivative claims, and the court held that he was excused from doing so. To determine whether demand was excused, the court applied the Aronson test for reviewing board inaction (Aronson v. Lewis, 473 A.2d 805 (Del. 1984)). Under Aronson, the plaintiff must allege facts that create a reasonable doubt regarding whether either:
  • The directors are disinterested and independent.
  • The challenged transaction was the product of a valid exercise of business judgment.
In Reith, the court held that demand is excused under both prongs of the Aronson test.
The defendants conceded that three of the seven board members were not disinterested and independent regarding the equity grants. The court held that the plaintiff alleged that a fourth board member would not be disinterested and independent in evaluating a demand concerning the equity grants because of his numerous important roles with Steel Holdings. Therefore, the plaintiff alleged facts showing that a majority of the company's board cannot impartially consider whether to pursue the plaintiff's claims relating to the equity grants.
Furthermore, under Delaware case law, demand is excused under the second prong of the Aronson test when a plaintiff adequately pleads that the board of directors knowingly or deliberately failed to follow the terms of a stock incentive plan (Pfeiffer v. Leedle, , at *5 (Del. Ch. Nov. 8, 2013)). Delaware precedent supports looking at a company's previous disclosures about its compensation plan to evaluate a board's decision about the plan's meaning. In Reith, the company told its stockholders in the 2010 proxy that the 2010 incentive award plan limited the number of Full Value Awards to three million. In 2017, the company granted more than three million Full Value Awards, which the court found to be a violation of the 2010 plan as described in the company's clear disclosures. Therefore, the plaintiff adequately pled that the board knowingly or deliberately failed to adhere to the terms of the 2010 plan.

Special Committee Defendants

The court held that the plaintiff adequately pled a non-exculpated derivative claim against the Special Committee defendants as to the equity grants. As required under Delaware law, the company's certificate of incorporation contains an exculpatory provision (8 Del. C. § 102(b)(7)). Normally, this would require a plaintiff to plead a non-exculpated claim against each independent director. However, that was not required in Reith. Demand is excused in Reith under the second prong of the Aronson test because the plaintiff pled that the Special Committee defendants knowingly approved the equity grants in violation of the 2010 plan, which implicates the duty of loyalty. Breaches of the duty of loyalty cannot be exculpated.

Breach of Fiduciary Duty

The court refused to dismiss the plaintiff's claim that the company's board of directors breached its fiduciary duties in approving the equity grants. Specifically, the plaintiff alleged that:
  • The defendant board members who were given the equity awards received an improper benefit from the expected stock bump from the IWCO acquisition because the value of the equity grants, which were made before the announcement of the IWCO acquisition, increased by more than 40% when the company announced the IWCO acquisition.
  • The size of the equity grants was "grossly unfair," particularly compared to awards given to the company's other directors and officers, and by the company's peers.
  • When the equity grants are added to the preferred stock, Steel Holdings and its affiliates received $48.7 million worth of stock for only $35 million. As a result, Steel Holdings obtained a majority of the company's outstanding stock.
Underlying these claims is a conflict of interest. Under Delaware law, entire fairness review applies when a company's board of directors acts under a conflict of interest (In re Trados Inc. S'holder Litig., 73 A.3d 17, 44 (Del. Ch. 2013)). The possibility that the entire fairness standard of review may apply tends to preclude the court from granting a motion to dismiss under Court of Chancery Rule 12(b)(6) (Hamilton P'rs, L.P. v. Highland Capital Mgmt., L.P., , at *12 (Del. Ch. May 7, 2014)).
The plaintiff's breach of fiduciary claim also survives dismissal under Rule 12(b)(6) because when a plaintiff in Delaware proves demand futility under the second prong of Aronson, as the plaintiff did in Reith, the plaintiff rebuts the business judgment rule for the purpose of surviving a motion to dismiss pursuant to Rule 12(b)(6) (Ryan v. Gifford, 918 A.2d 341, 357 (Del. Ch. 2007)).

Unjust Enrichment

Regarding the claim that several defendants, including Steel Holdings and SPH (a subsidiary of Steel Holdings), as well as three directors, were unjustly enriched by the equity grants, the court held that:
  • The plaintiff has alleged a derivative claim under Delaware law.
  • The complaint alleges facts sufficient to support the elements of an unjust enrichment claim because the plaintiff claims that the equity grants gave Steel Holdings majority voting control over the company. This theory survived the defendants' motion to dismiss the plaintiff's breach of fiduciary duty claim and the unjust enrichment claim.
  • The unjust enrichment claim is dismissed with respect to one corporate defendant (SPH) because the plaintiff alleges no connection between SPH and the equity grants, other than SPH's affiliation with Steel Holdings.

Disclosure

The plaintiff also alleges the director defendants breached the duty of candor through disclosure violations in the company's 2017 proxy. Under Delaware law, when stockholders approve a company's compensation plan, the company must disclose or provide a fair summary of the plan and any material extrinsic fact within the board's knowledge (Lewis v. Vogelstein, 699 A.2d 327, 333 (Del. Ch. 1997)). The plaintiff alleges that the 2017 proxy, among other deficiencies:
  • Did not disclose the full number of equity grants.
  • Did not disclose the existing three million limit for Full Value Awards that it sought to eliminate.
  • Affirmatively misrepresented the existing three million limit for Full Value Awards as applying only to the Recycled Awards.
Additionally, the company in the 2017 proxy asked stockholders to increase the shares available under the 2010 plan by an amount that would permit the equity grants. Stockholders were not told that the difference between the remaining equity grants and the three million limit on Full Value Awards also required approval, as required under the 2010 proxy.
The plaintiff also alleges the 2017 proxy did not disclose:
  • That the board granted the three directors more Full Value Award shares than the 2010 Plan allowed.
  • Why the company had run out of shares.
The court refused to dismiss the plaintiff's disclosure claim because it is reasonably conceivable that a stockholder considering whether to approve the amendments to the incentive award plan that were included in the 2017 proxy would want to know:
  • That the company previously believed the 2010 Plan limited Full Value Awards at three million shares.
  • The size of the equity grants relative to that limit.

Practical Implications

Although this is an unpublished opinion and the case has not yet reached an ultimate decision, Reith should serve as a reminder to corporate boards of directors to:
  • Review the process used to determine director equity awards.
  • Evaluate the reasonableness of equity awards before they are granted.
  • Provide detailed and accurate proxy disclosure regarding equity compensation plans and equity awards.
  • Adhere to the terms of the equity incentive plan and be aware of how potentially ambiguous terms in the plan have been described in the company's disclosure.