Changes to Corporate Capital in Equity Financing Transactions, Part II.

How Are Fiduciary Duties Applicable to Decisions Authorizing Changes to Corporate Capital?

The first post in this series analyzed whether shareholders may seek remedies in the context of charter amendments to facilitate changes to corporate capital in equity financings. The conclusion was that if an amendment to a corporate charter is properly adopted (and doesn’t violate an independent contractual obligation), shareholders can obtain a remedy only if the corporate action can substantiate a claim for breach of fiduciary duty against enough directors or control persons.

In situations where corporations are needy for additional capital, existing and potential stockholders often seek to maximize their potential benefits upon providing investments. They may control the company or control board seats. Some of the actions they take can adversely affect other shareholders’ interests. For instance, they may create a senior class of stock with superior right and preferences. Consequently, it is worthwhile to consider when shareholders can claim a breach of fiduciary duty in connection with equity financings or recapitalizations. This part of the series addresses how fiduciary duties of corporate directors and control persons apply in these circumstances in Texas and Delaware.

Directorial Fiduciary Duties in General

Directors owe fiduciary duties to the corporations they serve. In both Delaware and Texas, the two core fiduciary duties are the duty of care and the duty of loyalty. See Mill Acq. Co v. Macmillan, Inc. 559 A.2d 12611, 1280 (Del. 1989) and In re Estate of Poe, 591 S.W.3d 607, 639 (Tex.—El Paso, 2019), rev’d in part on other grounds, 443 S.W.3d 856 (Tex. 2014), (citing Gearheart Industries, Inc. v. Smith Intern., Inc. 741 F.2d 707, 719 (5th Cir. 1984). In Texas, the duty of loyalty has been described as requiring a director to “act in good faith and not to allow his or her personal interests to prevail over the interests of the corporation (also referred to as self-dealing).” In re Estate of Poe, at 63 (citing Gearheart Industries, 741 F.2d at 719). Similarly, Delaware courts have stated the duty of loyalty mandates that directors and in good faith and that “the best interest of the corporation and its shareholders takes precedence over any interest possessed by a director, officer or controlling shareholder not shared by the stockholders generally.” Cede & Co. v. Technicolor, Inc. 634 A.2d 345, 361 (Del. 1993). The duty of care generally “requires a director to be diligent and prudent in managing the corporation’s affairs.” In re Estate of Poe, at 63 (citing Gearheart Industries, 741 F.2d at 719); accord Cede & Co., 634 A.2d 345, 367-369 (Del. 1993).

Directorial Fiduciary Duties as Applied to Stockholders

In both Texas and Delaware, even if elected by a majority owner, directors owe duties to the shareholders as a collective through the corporation—and not to any specific shareholder. See Ritchie v. Rupe, 443 S.W.3d 856, 883 (Tex. 2014); also see Klaassen v. Allegro Dev. Corp., 2013 WL 5967028, at *11 (Del. Ch. Nov. 7, 2013) (citing Unocal Corp. v. Mesa Petroleum Co, 493 A.2d 946, 955 (Del. 1985). Texas courts emphasize the running of fiduciary duties to the corporation itself, as opposed to the stockholders. See In re Estate of Poe, — S.W.3d —, 2022 WL — (Tex. June 17, 2022) [20-0178]. In contrast, Delaware courts hold that directors owe duties directly to stockholders, including minority shareholders. See Revlon, Inc. v. MacAndrews & Forbes Holdings, Inc., 506 A.2d 173, 176 (Del. 1986); Odyssey Partners, L.P. v. Fleming Companies, Inc., 735 A.2d 386 (Del. Ch. 1999).

Fairness to Whom? That is the Question.

In many cases (but certainly not all), this may be a distinction without a difference. Texas courts do not determine the best interest of the corporation only through the perspective of majority shareholders. Ritchie, 883 n. 53 (Tex. 2014) (citing Holloway v. Skinner, 898 S.W.2d 793, 797 (Tex. 1995)). Generally, Texas courts will provide a remedy when controlling majority stockholders act to serve their own interest at the expense other shareholders. Id. However, in reviewing corporate actions for breach of fiduciary duty, Delaware courts extend fairness evaluations further in favor of stockholders. Compare In re Estate of Poe, — S.W.3d — (Tex. 2022) (holding that the trial court improperly instructed the jury to evaluate a transaction’s fairness to the plaintiff shareholder, instead of to the corporation) with Emerald Partners v. Berlin, 787 A.2d 85 (Del. 2001) (holding that in a fairness review, the question is whether the challenged transaction was entirely fair to the shareholder plaintiff). The Delaware Supreme Court has construed the fiduciary duty relationship as shouldering directors with a “basic duty of fairness” and a “requirement to treat shareholders and their equity interest in the corporation fairly.” Solomon v. Armstrong, 747 A.2d 1098, 1111 (Del. Ch. 1999).

Duties as Applied to Preferred Shareholders

Duties to preferred stockholders are “primarily . . . contractual in nature as they involve the rights and obligations created by a certificate of incorporation or a designation. See WatchMARK Corp. v. Argo Global Capital, Civil Action No. 711-N, at *1 (Del. Ch. Nov. 4, 2004); Rothschild Intern. Corp. v. Liggett Group, 474 A.2d 133 (Del. 1984); see also Wineinger v. Farmers’ Stockmen’s Loan, 278 S.W. 932, 935 (Tex.Civ.App. 1926); Cotten v. Weatherford Bancshare, Inc., 187 S.W.3d 687 (Tex.App. 2006), disapproved on other ground by Ritche, 443 S.W.3d 856, 866 (Tex. 2014). Their preferences must be clearly expressed and “will not be presumed.” Rothschild, 474 A.2d 133 (Del. 1984). Additionally, Delaware courts have held that preferred stockholders are owed fiduciary duties only when the right allegedly harmed “is shared equally with the common stock.” In re Trados Inc. S’holder Litig., 73 A.3d 17, 39-40 (Del. Ch. 2013). Texas courts do not appear to have addressed the scope of general corporate fiduciary duties as applied to claims of preferred stockholders. But given their focus on duties owed to the corporation and the shareholders collectively, it seems likely Texas Courts would agree that there are circumstances in which control persons can breach fiduciary duties to corporations through changes to corporate capital that result in harm to preferred shareholders.

Controlling Stockholders and Fiduciary Duties  

In addition to directors, controlling stockholders can owe fiduciary duties to the corporation in certain situations because they can act selfishly “to the detriment of the corporation’s minority stockholders. In re Nine Sys. Corp. S’holders Litig., 2014 WL 4383127, at *61 (Del. Ch. Sep. 4, 2014). This includes when they “stand on both sides of [a] transaction” with the corporation. Id. Both Delaware and Texas courts recognize this principal, but Texas case law is not as developed regarding the situations in which controlling stockholders have such duties. Nonetheless, Texas courts will apply fiduciary duties to controlling stockholders or groups when they act “as directors.” See Ritchie v. Rupe, 443 S.W.3d 856, 883 (Tex. 2014) (citing Int’l Bankers Life Ins. Co. v. Holloway, 368 S.W.2d 567, 577 (Tex. 1963); Gearheart Industries, inc. v. Smith Intern., Inc. 741 F.2d 707, 719 (5th Cir. 1984)). Practically, this means that in both Texas and Delaware minority stockholders can, on behalf of the corporation, seek relief against controlling stockholders when they act in manner that favors their own interests and harms the corporation or other shareholders.

Conclusion – Insider Financings Create the Most Risk

Consistent with the “twice-testing” principle, a stockholder can challenge actions taken in furtherance of an equity financing on the grounds they were in breach of the duty of care or the duty of loyalty. For example, if the price at which newly issued shares are offered to an outside party is unreasonably low given the value of the company, board members may be sued for having failed to exercise due care in informing themselves of the value of the company or in failing to seek an investor willing to pay a higher price. But most saliently, directors and controlling stockholders who approve actions in furtherance of dilutive equity financings and recapitalizations are subject to claims of breach of fiduciary duty when they are interested in the transaction.

When insiders seek to benefit themselves or associated persons by leveraging board or other control positions, they become exposed to claims for breach of the duty of loyalty and the evaluation of actions under fairness reviews. In these circumstances, in both Texas and Delaware, the affected shareholders may bring derivative fiduciary duty actions for any injury sustained by the corporation through a charter amendment and recapitalization. In some cases, they may bring direct claims. The likelihood that a finder of fact determines a director or controlling shareholder breached a duty in approving or taking a corporate action will depend on the standard of review applied in analyzing the challenged corporate actions. The next post in this series will focus on the standards of review applied by Texas and Delaware courts in evaluating compliance with fiduciary duties in corporate transactions resulting in equity dilution.

 

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