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Oct 6, 2021

Delaware Supreme Court Overturns Itself in Holding That Stock Dilution Claims Are Solely Derivative

When the Delaware Supreme Court takes the rare step of reversing itself on a corporate law issue of institutional significance, corporate lawyers and their clients alike should take heed. The Delaware Supreme Court did just that when, on September 20, 2021, it issued a decision in Brookfield Asset Mgmt. v. Rosson overturning its prior decision from 2006 in Gentile v. Rossette

In Gentile, the Delaware Supreme Court carved out a narrow exception permitting a minority stockholder to bring direct claims for stock dilution arising from an issuance of stock to a controlling shareholder in a situation where the minority stockholder lacked standing to assert a derivative claim. Ordinarily, a stockholder can only bring such a claim derivatively, not directly. However, in Gentile, the Delaware Supreme Court pronounced an exception to this rule, recognizing a dual “species” of a dilution claim that is both direct and derivative in a situation where:

(1) a [controlling] stockholder . . . causes the corporation to issue “excessive” shares of its stock in exchange for assets of the controlling stockholder that have a lesser value; and (2) the exchange causes an increase in the percentage of the outstanding shares owned by the controlling stockholder and a corresponding decrease in the share percentage owned by the public (minority) stockholders.1

Ten years after Gentile, in its 2016 decision in El Paso Pipeline GP Co., L.L.C. v. Brinckerhoff, the Delaware Supreme Court elucidated on the rule it pronounced in Gentile, holding that a minority stockholder can only bring a direct (as opposed to derivative) claim for dilution if it involves the issuance of stock in exchange for a controller’s assets, resulting in the transfer of both economic and voting power from the minority stockholder directly to the controller.2 Thus, in El Paso, the Delaware Supreme Court made clear that the Gentile exception is extremely narrow. It declined to authorize a direct claim whenever a controller deals unfairly with the controlled company, and instead held that such a claim may only be brought under these narrow circumstances.

In his widely-discussed concurrence in El Paso, then-Chief Justice of the Delaware Supreme Court, Leo Strine observed that there was an abundance of confusion among trial courts in determining the specific facts that fit within the Gentile paradigm. Chief Justice Strine wrote that Gentile “cannot be reconciled with the strong weight of our precedent,” thereby raising the question of whether Gentile is still good law.

Fast forward five years after El Paso to September 20, 2021 when the Delaware Supreme Court, in Brookfield Asset Mgmt., finally put the issue to rest. The dispute in Brookfield Asset Mgmt. arose in connection with a private placement issued by TerraForm Power (“TP”). Brookfield Asset Management and its affiliates (together, “Brookfield”) were controlling shareholders of TP. Brookfield increased its ownership of TP from 51% to 61.5% by acquiring additional shares of TP in the private placement. Subsequently, the minority stockholders of TP brought a stockholder derivative action and a direct, putative class action lawsuit asserting a dilution claim.  In the lawsuit, TP’s minority stockholders alleged that Brookfield caused TP to issue the stock in the private placement for insufficient value, and that the stock issuance wrongfully diluted the minority stockholders’ economic and voting interests in TP. Shortly after the lawsuit was filed, Brookfield acquired the remainder of TP’s stock to become the 100% owner of TP.

Brookfield sought to dismiss the lawsuit in its entirety on the ground that (1) the minority stockholders had brought a dilution claim which, Brookfield argued, could only be brought derivatively (as opposed to both derivatively and directly), and that (2) the minority stockholders had lost standing to sue derivatively under Delaware’s “continuous ownership” rule because they ceased to be stockholders in TP once Brookfield had become the 100% owner of TP. 

The Delaware Court of Chancery denied Brookfield’s motion to dismiss, finding that the alleged facts of the lawsuit fit squarely into the narrow carve out under Gentile which allowed the minority stockholders to assert a dilution claim both directly and derivatively. The Court of Chancery held that its decision was “unsatisfying,” but that it was “not free to decide cases in a way that deviates from [the] binding Supreme Court precedent” of Gentile. Brookfield then filed a motion before the Chancery Court to certify an interlocutory appeal of the decision, which the Court of Chancery granted.

On appeal, the Delaware Supreme Court unanimously reversed the Court of Chancery’s decision denying Brookfield’s motion to dismiss, expressly overruling its decision in Gentile. In so doing, the Delaware Supreme Court first held that its holding in Gentile (i.e., dilution by controlling shareholders created not only a shareholder derivative claim, but also, under the narrow carve-out, a separate, and direct claim arising out of that same transaction) was incorrect.  In rejecting the Gentile “carve out,” the Delaware Supreme Court noted that Gentile incorrectly focused on the identity of the wrongdoer, i.e, the controlling stockholder, as opposed to the identity of the party suffering the injury; i.e., the minority stockholders. Next, the Delaware Supreme Court observed that there were other exceptions apart from the carve out in Gentile upon which minority stockholders could rely on to bring direct claims for dilution (for instance, claims under the Delaware Supreme Court’s seminal 1986 holding in Revlon, Inc. v. MacAndrews & Forbes Holdings, Inc., which requires target company directors, when engaged in a sale of a Delaware company, to seek the highest value reasonably available to stockholders under the circumstances). Finally, the Delaware Supreme Court observed that in the over-15 years that had transpired since Gentile, “the practical and analytical difficulties courts have encountered in applying [Gentile] reflect fundamental unworkability.”

How the Court’s Decision in Brookfield Asset Mgmt. May Impact You

Distilled to its essentials, the Delaware Supreme Court’s decision in Brookfield Asset Mgmt. means that stockholders can no longer directly sue controlling shareholders of Delaware companies for diluting the value of their shares or their voting rights. Rather, from this moment forward such claims can only be brought derivatively. Thus, even when a controller causes a company to engage in a wrongful stock transaction that improperly dilutes the minority stockholders, the minority stockholders will not be able to assert a direct claim. However, Delaware law requires that a stockholder must be a shareholder at the time of suit to sue derivatively. Therefore, minority stockholders facing such a situation will only be able to sue derivatively, but their ability to do so will be irrevocably lost in the post-merger context when they lose their status as stockholders. For these reasons, minority stockholders faced with a controller who has expropriated economic and voting power to dilute the minority’s ownership interest should take note that once a merger occurs, they will be left without recourse. In view of this, minority shareholders who believe they are facing dilution of their shares due to oppressive acts of a controller should now, more than ever before, consider promptly bringing a derivative action or pursuing other potential legal avenues (e.g., a demand for the company’s books and records) on a time-sensitive basis against such a controller. 

* * *

 If you have any questions about the issues addressed in this memorandum, or if you would like a copy of any of the materials mentioned in it, please do not hesitate to call or email authors Stuart Riback (partner) at 212.981.2326 or sriback@wilkauslander.com, or Scott Watnik (partner) at 646.375.7658 or swatnik@wilkauslander.com

[1] Gentile, 906 A.2d at 99-100.

[2] El Paso, 152 A.3d at 1263-64.