How do the courts determine whether a shareholder’s claim is direct or derivative?
Under Delaware law, a "derivative suit" is one which enables a stockholder to bring a suit on behalf of the corporation for harm done to the corporation. (Brookfield Asset Mgmt., Inc. v. Rosson, 261 A.3d 1251 (Del. 2021))
Because a derivative suit is brought on behalf of the corporation, any recovery must go to the corporation. (Brookfield Asset Mgmt., Inc. v. Rosson, 261 A.3d 1251 (Del. 2021))
In contrast, in order for a suit to be direct, a shareholder must have suffered some individualized harm not suffered by all of a company's other shareholders at large. (Feldman v. Cutaia, 951 A.2d 727 (Del. 2008))
A stockholder's direct injury must be independent of any alleged injury to the corporation. The duty breached must have been owed to the stockholder such that the stockholder can prevail without showing an injury to the corporation. (Tooley v. Donaldson, Lufkin & Jenrette, 2004 WL 728354, 845 A.2d 1031 (Del. 2004))
Whether a shareholder's claim is direct or derivative turns on two questions: (1) who suffered the alleged harm (the corporation or the suing stockholders, individually); and (2) who would receive the benefit of any recovery or other remedy (the corporation or the stockholders, individually)? (Tooley v. Donaldson, Lufkin & Jenrette, 2004 WL 728354, 845 A.2d 1031 (Del. 2004))
For example, in El Paso Pipeline GP Co., L.L.C. v. Brinckerhoff, 152 A.3d 1248 (Del. 2016) the Supreme Court of Delaware reversed a lower court's ruling that a shareholder's claim was direct and, instead, held the shareholder's claim was derivative because the claim alleged harm to the shareholder's partnership and sought to recover damages on behalf of the partnership. Specifically, the plaintiff alleged that the defendants caused the partnership to overpay on a transaction
Similarly, in In re J.P. Morgan Chase & Co. S'Holder Lit., 906 A.2d 808 (Del. Ch. 2005) the Delaware Court of Chancery held that, where shareholders were harmed indirectly as the result of a corporation's merger funded by stock, the shareholders' claim was derivative, not direct, as further evidenced by the fact that any remedy from the alleged harm would accrue to the corporation.
In certain circumstances, however, a shareholder's claim or claims may be both direct and derivative. (In re Nine Sys. Corp. S'holders Litig., 2014 Del. Ch. LEXIS 171 (Del. Ch. Sep. 4, 2014))
For example, in Gatz v. Ponsoldt, 925 A.2d 1265 (Del. 2007) the Supreme Court of Delaware held that, where a corporation's minority shareholders sought to recover damages as the result of a recapitalization and aggregate sale of the corporation, the shareholders' claims were not exclusively derivative and, therefore, could be brought directly as well.
In Brookfield Asset Mgmt. v. Rosson, 261 A.3d 1251 (Del. 2021), the Supreme Court of Delaware explained that a derivative suit is an action brought on behalf of a corporation for harm done to the corporation, while a direct suit is an individual action for injuries suffered by a particular stockholder (at 1262-1263):
A derivative suit enables a stockholder to bring a suit on behalf of the corporation for harm done to the corporation.38 Because a derivative suit is
[261 A.3d 1263]
brought on behalf of the corporation, any recovery must go to the corporation. However, a stockholder who is directly injured retains the right to bring an individual action for injuries affecting his or her legal rights as a stockholder.39 "Such a claim is distinct from an injury caused to the corporation alone."40 In such individual suits, "the recovery or other relief flows directly to the stockholders, not to the corporation."41 Classification of a particular claim as derivative or direct can be difficult.42 Further, "[t]he decision whether a suit is direct or derivative may be outcome-determinative."43 Such is the case here as the central question is whether Plaintiffs have direct standing to pursue their claims or whether their claims are entirely derivative. If the latter, then their claims were extinguished in the Merger, and they lack standing to pursue them.
In Tooley v. Donaldson, Lufkin & Jenrette, 2004 WL 728354, 845 A.2d 1031 (Del. 2004) ("Tooley"), the Supreme Court of Delaware explained that the test for determining whether a stockholder's claim is derivative or direct turns on who suffered the harm and who would receive the benefit of any recovery or other remedy (at 1033, 1035-1036):
Although the trial court's legal analysis of whether the complaint alleges a direct or derivative claim reflects some concepts in our prior jurisprudence, we believe those concepts are not helpful and should be regarded as erroneous. We set forth in this Opinion the law to be applied henceforth in determining whether a stockholder's claim is derivative or direct. That issue must turn solely on the following questions: (1) who suffered the alleged harm (the corporation or the suing stock-holders, individually); and (2) who would receive the benefit of any recovery or other remedy (the corporation or the stock-holders, individually)?
The analysis must be based solely on the following questions: Who suffered the alleged harm — the corporation or the suing stockholder individually — and who would receive the benefit of the recovery or other remedy? This simple analysis is well imbedded in our jurisprudence,7 but some cases have complicated it by injection of the amorphous and confusing concept of "special injury."
[845 A.2d 1036]
The Chancellor, in the very recent Agostino case,8 correctly points this out and strongly suggests that we should disavow the concept of "special injury." In a scholarly analysis of this area of the law, he also suggests that the inquiry should be whether the stockholder has demonstrated that he or she has suffered an injury that is not dependent on an injury to the corporation. In the context of a claim for breach of fiduciary duty, the Chancellor articulated the inquiry as follows: "Looking at the body of the complaint and considering the nature of the wrong alleged and the relief requested, has the plaintiff demonstrated that he or she can prevail without showing an injury to the corporation?"9 We believe that this approach is helpful in analyzing the first prong of the analysis: what person or entity has suffered the alleged harm? The second prong of the analysis should logically follow.
The Court explained that a stockholder's direct injury must be independent of any alleged injury to the corporation. The duty breached must have been owed to the stockholder such that the stockholder can prevail without showing an injury to the corporation (at 1038-1039):
Thus, two confusing propositions have encumbered our caselaw governing the direct/derivative distinction. The "special injury" concept, applied in cases such as Lipton, can be confusing in identifying the nature of the action. The same is true of the proposition that stems from Bokat — that an action cannot be direct if all stockholders are equally affected or unless the
[845 A.2d 1039]
stockholder's injury is separate and distinct from that suffered by other stockholders. The proper analysis has been and should remain that stated in Grimes; Kramer and Parnes. That is, a court should look to the nature of the wrong and to whom the relief should go. The stockholder's claimed direct injury must be independent of any alleged injury to the corporation. The stockholder must demonstrate that the duty breached was owed to the stockholder and that he or she can prevail without showing an injury to the corporation.
In Feldman v. Cutaia, 951 A.2d 727 (Del. 2008), the Supreme Court of Delaware explained that, for a suit to be direct, a shareholder must have suffered some individualized harm not suffered by all of the company's stockholders at large (at 733):
Where all of a corporation's stockholders are harmed and would recover pro rata in proportion with their ownership of the corporation's stock solely because they are stockholders, then the claim is derivative in nature. The mere fact that the alleged harm is ultimately suffered by, or the recovery would ultimately inure to the benefit of, the stockholders does not make a claim direct under Tooley. In order to state a direct claim, the plaintiff must have suffered some individualized harm not suffered by all of the stockholders at large.
In El Paso Pipeline GP Co., L.L.C. v. Brinckerhoff, 152 A.3d 1248 (Del. 2016), the Supreme Court of Delaware reversed a lower court's ruling that the plaintiff's claim was direct and, instead, held that the plaintiff's claim was derivative because, among other things, the plaintiff's claim alleged harm to the limited partnership and sought to recover damages on behalf of the partnership. Specifically, the plaintiff alleged that the defendants caused the partnership to overpay on a transaction (at 1250-1251, 1260-1261, 1264-1265):
In a detailed, well-reasoned decision, the Court of Chancery held that a conflicts committee approved a conflict transaction that it did not believe was in the best interests of the limited partnership it was charged with protecting. In fact, the court found that the committee—and the committee's financial advisor in particular—knew the transaction was unduly favorable to the limited partnership's general partner. In its post-trial opinion, the Court of Chancery undertook a detailed analysis explaining why $171 million was a conservative estimate of the overpayment approved by the committee and used that figure as the basis for its damages award.
But the problem for the derivative plaintiff who won at trial is that, after the trial was completed and before any judicial ruling on the merits, the limited partnership was acquired in a merger. Under 6 Del. C. § 17–211(h)1 and analogous judicial authority governing these situations,2 the claims brought by the plaintiff on behalf of the limited partnership were transferred to the buyer in the merger. The plaintiff's standing was extinguished, and his only recourse was to challenge the fairness of the merger by alleging that the value of
[152 A.3d 1251]
his claims was not reflected in the merger consideration.
The Court of Chancery, however, rejected the defendants' argument to this effect and issued a thoughtful opinion arguing that the derivative plaintiff's claims, although always treated by him as derivative before the merger was announced, could also be considered direct, or, even if derivative, should survive the merger for the core policy reason that dismissal would leave the unaffiliated limited partners without recompense for the general partner's prior unfair dealing.
In this troubling case, we reverse. We find that the derivative plaintiff's claims were and remain derivative in nature. That a limited partner is often, as is the case here, required to look to the entity's foundational agreement rather than to default principles of equity law for protection does not mean that every claim for breach of those foundational agreements is direct. Rather, to determine if a claim is derivative or direct requires the usual examination of who owns the claim.
Because Brinckerhoff's claim sounds in breach of a contractual duty owed to the Partnership, we employ the two-pronged Tooley51 analysis to determine whether the claim "to enforce the [Partnership's] own rights must be asserted derivatively"52 or is dual in nature such that it can proceed directly.53 We have observed that "[t]he Tooley direct/derivative test is ‘substantially the same’ for claims involving limited partnerships."54 While the test may be substantially the same, cases involving limited partnerships often present unique facts relating to the provisions and structure of the limited partnership agreement and how it defines the rights and responsibilities of the limited partners.55
Under Tooley, whether a claim is solely derivative or may continue as a dual-natured claim "must turn solely on the following questions: (1) who suffered the alleged harm (the corporation or the suing stockholders, individually); and (2) who would receive the benefit of any recovery or other remedy (the corporation or the stockholders, individually)?"56 In addition, to prove that a claim is direct, a plaintiff "must demonstrate that the duty breached was owed to the stockholder and that he or she can prevail without showing an injury to the corporation."57
Applying the first prong of Tooley, the harm alleged in Brinckerhoff's complaint solely affected the Partnership. The Fall Complaint alleged injury to Brinckerhoff only in terms of the alleged harm to the Partnership.58 The "core theory" of
[152 A.3d 1261]
Brinckerhoff's complaint "was that ‘the Partnership was injured’ when the defendants caused [the Partnership] to pay too much" in the Fall Dropdown.59 Such claims of corporate overpayment are normally treated as causing harm solely to the corporation and, thus, are regarded as derivative.60 In Tooley terms, the harm is to the corporation, because such claims "naturally assert that the corporation's funds have been wrongfully depleted, which, though harming the corporation directly, harms the stockholders only derivatively so far as their stock loses value."61 The recovery—"restoration of the improperly reduced value"—flows to the corporation.62
As to the second prong of Tooley, the benefit of any recovery must flow solely to the Partnership. The Court of Chancery recognized that "returning the full amount [of the overpayment] to the entity" was the "most obvious" remedy,80 and that Brinckerhoff sought to recover damages "on behalf of" the Partnership.81 Were Brinckerhoff to recover directly for the alleged decrease in the value of the Partnership's assets, the damages would be proportionate to his ownership interest. The necessity of a pro rata recovery to remedy the alleged harm indicates that his claim is derivative.82
In deviating from an entity-level remedy, the Court of Chancery relied on cases involving "insider transfers" of stock and "stock dilution cases [,]" which it read to permit remedies "at the stockholder level, without any payment to the corporation, such as an order adjusting the rights of the stock or invalidating a portion of the shares."83 As discussed above, these cases are inapposite, as Brinckerhoff does not claim that the Fall Dropdown affected his voting rights or the Parent's relative control of the Partnership.84
[152 A.3d 1265]
Finally, Brinckerhoff never presented evidence at trial of specific harm suffered by the limited partners, as the Court of Chancery stated. It follows that the General Partner should not be penalized for failing to defend at trial an element of a claim (e.g., that the unitholders were directly harmed by the Fall Dropdown) that the plaintiff never attempted to prove.85
Thus, Brinckerhoff's overpayment claim is exclusively derivative under Tooley.
In In re J.P. Morgan Chase & Co. S'Holder Lit., 906 A.2d 808 (Del. Ch. 2005), two banks agreed to a merger. One bank paid a premium over the market share price for the other bank, making one bank the acquirer and the other bank the target. After the merger was completed, the stockholders of the acquirer sued its directors for breach of fiduciary duty, alleging that they paid too much. They also argued that these were direct claims. The Court of Chancery of Delaware held that the shareholders were harmed indirectly and therefore the claim was derivative, not direct (at 817-819):
The court begins by analyzing whether the stated claims are direct or derivative. The Delaware Supreme Court recently revised the standard for determining whether a claim is direct or derivative to "turn solely on the following questions: (1) who suffered the alleged harm (the corporation or the suing stockholders, individually); and (2) who would receive the benefit of any recovery or other remedy (the corporation or the stockholders, individually)?"19 "[U]nder Tooley, the duty of the court is to look at the nature of the wrong alleged, not merely at the form of words used in the complaint."20 "Instead the court must look to all the facts of the complaint and determine for itself whether a direct claim exists."21
The plaintiffs' main complaint is that the defendant directors breached their fiduciary duty by approving a merger exchange ratio that paid an unnecessary or excessive premium to Bank One stockholders. This premium, the plaintiffs argue, prevented them from receiving their fair share of the resulting business combination, causing them to be harmed directly through dilution of their collective ownership percentage.
1. Who Suffered The Alleged Harm?
In order to show a direct injury under Tooley, a "stockholder must demonstrate that the duty breached was owed to the stockholder and that he or she can prevail without showing an injury to the corporation."22
By describing the harm as a dilution of their stockholder interests, the plaintiffs attempt to allege a harm to them that does not affect the corporation. But their argument fails to acknowledge the context in which they were allegedly harmed. "[A] complaint that `directly challenges the fairness of the process and the price' of a merger suggests ... that the corporation suffered harm ... and that the harm suffered by stockholders is only a natural and foreseeable consequence of the harm to the corporation."23 At the heart of their complaint, the plaintiffs claim that JPMC overpaid for Bank One. If JPMC had paid cash for Bank One, the plaintiffs' claim would clearly be derivative. JPMC would have suffered the alleged harm by paying too much money for Bank One. Any such cash overpayment would not have harmed the stockholders of JPMC directly. The only harm to the stockholders would have been the natural and foreseeable consequence of the harm to JPMC.
The fact that this transaction was effectuated by issuing stock and not by paying cash does not change the result. The harm, if any, was still suffered by JPMC. Although "dilution claims emphasizing the diminishment of voting power have been categorized as direct claims,"24 "[they] are individual in nature [only] where a significant stockholder's interest is increased at the sole expense of the minority."25 "[T]o the extent that any alleged decrease in the asset value and voting power of plaintiffs' shares ... results from the issuance of new equity to a third party ..., plaintiffs' dilution theory as a basis for a direct claim fails and any individual claim for dilution must be dismissed."26
Here, the plaintiffs rely on the claim of "dilution" in an attempt to frame the harm as direct. But, they do not allege any stockholder dilution in relation to premerger voting rights. Instead, their claim of dilution is related to the issuance of stock to consummate the merger. This dilution claim is based on the merger exchange ratio, which was a necessary result of the purchase price for Bank One. Any alleged dilution was a harm suffered by all pre-merger JPMC stockholders and, consequently, JPMC itself. Thus, the harm alleged in the complaint cannot give rise to a direct claim.
In response to the court's request for support "for the proposition that a claim which would undoubtedly be a derivative claim is somehow converted into a direct claim because of the form of consideration,"27 the plaintiffs were not able to cite any persuasive authority. Indeed, in their post-hearing submissions, the plaintiffs were unable to point to any authority under Delaware law that the direct/derivative analysis is affected by the form of consideration used in a transaction. In fact, Delaware case law states that "if a board of directors authorizes the issuance of stock for no or grossly inadequate consideration, the corporation is directly injured and shareholders are injured derivatively."28 Furthermore, as Chancellor
Chandler has recently noted, "[m]ere claims of dilution, without more, cannot convert a claim traditionally understood as derivative, into a direct one."29 Thus, the plaintiffs' argument that they were harmed directly because the merger consideration was stock instead of cash must fail as a matter of law.
Putting the 14% premium payment in the proper context, the court finds that any alleged harm was suffered by JPMC, regardless of whether the payment was in cash or in stock. The plaintiffs, if they were harmed at all, were harmed indirectly and only because of their ownership in JPMC. Therefore, under the first prong of Tooley, the court concludes that the plaintiffs' claim is derivative.
2. Who Would Receive The Benefit Of Any Recovery Or Other Remedy?
Under the second prong of Tooley, in order to maintain a direct claim, stockholders must show that they will benefit from the remedy.30 Here, the plaintiffs seek a return of the "proper interest"31 of JPMC to stockholders who owned pre-merger JPMC stock, but they offer no explanation of what such a proper interest might be. Additionally, the plaintiffs are unable to demonstrate why they, and not JPMC, should receive the benefit of any remedy.
As discussed above, if there was harm suffered by payment of a merger premium, JPMC suffered it. Thus, if the defendants are found liable, the remedy will accrue to JPMC. Although the plaintiffs go to great lengths to define the class in a way that would allow them to argue for a direct class benefit, their effort to make the claim direct fails. The plaintiffs' argument that the previous Bank One stockholders, who ostensibly have already benefited from any misconduct, should be excluded from the remedy is not persuasive. Any remedy from the alleged harm would necessarily accrue to JPMC and not to a subset of stockholders. Therefore, the plaintiffs' claims are derivative under the second question of Tooley.
In In re Nine Sys. Corp. S'holders Litig., 2014 Del. Ch. LEXIS 171 (Del. Ch. Sep. 4, 2014), the Court of Chancery of Delaware explained that, in certain circumstances, a claim may be both direct and derivative (at 64-68):
The Delaware Supreme Court defined how to distinguish between direct and derivative claims in Tooley v. Donaldson, Lufkin & Jenrette, Inc. Under Tooley, the Court's inquiry involves answering [*65] two questions: "(1) who suffered the alleged harm (the corporation or the suing stockholders, individually); and (2) who would receive the benefit of any recovery or other remedy (the corporation or the stockholders, individually)?" Harm to the corporation or to the stockholders pro rata with their stock ownership would typically give rise to a derivative claim. In contrast, harm unique to the stockholders—the classic example of which is the board's failing to disclose all material information when seeking stockholder action—would give rise to a direct claim. At times, divining a direct claim from a derivative claim is not a straightforward exercise, as certain wrongful conduct appears to harm stockholders derivatively and directly. "Courts have long recognized that the same set of facts can give rise both to a direct claim and a derivative claim." Most relevant here, in Gentile v. Rossette (Gentile II), the Delaware Supreme Court again acknowledged that the Tooley test is not necessarily a binary choice: "[t]here is . . . at least one transactional paradigm—a species of corporate overpayment claim—that Delaware case law recognizes as being both derivative and direct in character."
The Gentile case featured allegations that a controlling stockholder who owned convertible promissory notes caused the corporation to permit him to convert the notes at a conversion rate lower than that specified in the relevant contracts. Through the debt conversion, the controlling stockholder increased his equity ownership from approximately to 61% to 93.5%. The corporation then merged with a third party, and only after the merger did the plaintiffs (who were stockholders before the merger) learn the terms of the debt conversion.
Because the plaintiffs were minority stockholders before and after the debt conversion, the trial court concluded that their breach of fiduciary duty claim was solely derivative in nature under Tooley such that they lost standing to pursue the claim under the continuous ownership rule. The Supreme Court, however, reversed and concluded that the plaintiffs' claim for "expropriation" against the corporation's controlling stockholder could be asserted derivatively and directly:
A breach [*67] of fiduciary duty claim having this dual character arises where: (1) a stockholder having majority or effective control 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) shareholders. Because the means used to achieve that result is an overpayment (or "over-issuance") of shares to the controlling stockholder, the corporation is harmed and has a claim to compel the restoration of the value of the overpayment. That claim, by definition, is derivative.
But, the public (or minority) stockholders also have a separate, and direct, claim arising out of that same transaction. Because the shares representing the "overpayment" embody both economic value and voting power, the end result of this type of transaction is an improper transfer—or expropriation—of economic value and voting power from the public shareholders to the majority or controlling stockholder. For that reason, the harm resulting from [*68] the overpayment is not confined to an equal dilution of the economic value and voting power of each of the corporation's outstanding shares. A separate harm also results: an extraction from the public shareholders, and a redistribution to the controlling shareholder, of a portion of the economic value and voting power embodied in the minority interest. As a consequence, the public shareholders are harmed, uniquely and individually, to the same extent that the controlling shareholder is (correspondingly) benefited.
The Recapitalization here was a stock issuance that, primarily through the Preferred B-1 stock that Wren and Javva received, proportionately diluted the Plaintiffs' stock holdings in the Company. That the Recapitalization did not increase Wren and Javva's ownership of the Company "to the same extent" that it diluted Plaintiffs' equity (since investors other than the Defendants would receive Preferred A stock) does not change the Court's conclusion that the Recapitalization may have given rise to direct and derivative harm. Whether the Plaintiffs have standing to challenge this expropriation directly is a separate question.
In Gatz v. Ponsoldt, 925 A.2d 1265 (Del. 2007), the Supreme Court of Delaware held that, where a corporation's minority shareholders sought to recover damages as the result of a recapitalization and aggregate sale of the corporation, the shareholders' claims were not exclusively derivative and, therefore, could be brought directly as well (at 1277, 1279-1281):
As earlier noted, the Appellants argue that their Recapitalization claim could be brought as a direct claim for two independent reasons. First (Appellants contend), that claim alleges a claim for breach of fiduciary duty under Revlon, which by definition is a direct claim. Specifically, the Recapitalization is alleged to have involved a transfer of majority control from Regency's public shareholders to Royalty/Levy without the payment of a control premium to the public shareholders. Second, Appellants contend, the complaint alleges a direct claim for breach of fiduciary duty under Tri-Star and Rossette, because the Recapitalization constituted an expropriation of voting power and economic value from Regency's public stockholders, and a transfer of that voting power and economic value to Levy/Royalty, to the corresponding detriment of Regency's public shareholders—all accomplished by Regency's de facto controlling stockholder, Statesman/Ponsoldt. Because we conclude that the Recapitalization claim may be brought as a direct claim under Tri-Star and Rossette, we do not reach or decide the Appellants' Revlon-based argument.
The only basis for the Appellees' argument that the Recapitalization claim is not direct under Tri-Star and Rossette, is their attempted portrayal of the Recapitalization as a unitary transaction in which: (1) majority control is transferred in an arms' length exchange from the public shareholders to a non-fiduciary third party having no previous stock ownership in the corporation, and (2) the (former) controlling stockholder receives no corresponding benefit from any increased voting power or economic value expropriated from the public shareholders. This scenario, the Appellees contend, falls outside the transactional paradigm that triggers the application of Tri-Star and Rossette.
At first glance, that argument appears to have force. The argument disintegrates, however, once the Recapitalization is scrutinized more intensively and in terms of its (alleged) true substantive effect. Looking through the form of the transaction to its substance, it becomes apparent that the Recapitalization is properly analyzed as two separate transactions that Ponsoldt and Levy, by creative timing and coordination, caused simultaneously to be rolled into one. The first of those transactions (transaction # 1) was a Tri-Star/Rossette expropriation of voting power and economic value from the public shareholders by and to the controlling shareholder; and the second (transaction # 2) was a transfer of the benefits of that expropriation by the controlling shareholder to the third party. Causing both transactions to occur simultaneously obscures the effects of the first transaction if the latter were considered in isolation.
To elaborate, transaction # 1 would simply substitute Ponsoldt for Regency, so that it is Ponsoldt who deals directly with Royalty/Levy. Thus: Royalty/Levy loans the same $4.75 million to Ponsoldt, rather than to Regency. In exchange, Ponsoldt delivers to Royalty/Levy his personal $4.75 million promissory note. Ponsoldt then transfers the $4.75 million to Regency (controlled by Ponsoldt). Regency then: (i) pays $4 million to Statesman (controlled by Ponsoldt) to redeem the 754,950 Regency shares held by Statesman, and (ii) pays Ponsoldt $4.75 million in the same two promissory notes, including the $3.5 million note convertible into 1.75 million Regency shares. Ponsoldt then immediately converts the $3.5 million note into 1.75 million Regency shares.
Thus, in transaction # 1, Ponsoldt, as the de facto controller of Regency and Statesman, ends up as the absolute majority stockholder of Regency, to the corresponding detriment of the Regency public shareholders. If in exchange (as the complaint here alleges) Regency received value that was less than the value of the 1.75 million shares newly issued to Ponsoldt, then this transaction clearly falls within the ambit of Tri-Star/Rossette, and any claim for redress by Regency's public stockholders could be brought directly.
In transaction # 2, Ponsoldt merely completes the circle by substituting Royalty/Levy
[925 A.2d 1280]
for himself as the new controller of Regency, as (it is alleged) actually occurred in the Recapitalization. That is, Ponsoldt transfers his newly-acquired controlling stock interest in Regency (equivalent in value to $3.5 million), plus the $1.25 million Regency note, to Royalty/Levy. In exchange, Royalty/Levy cancels the Ponsoldt $4.75 million promissory note, and then proceeds to take control of Regency's board of directors. That is, in transaction # 2 the initial $4.75 million financing that Ponsoldt, rather than Regency, received, would simply be unwound. That done, the result is substantively identical to what in fact occurred in the Recapitalization.
If transactions # 1 and # 2 were structured and timed to occur simultaneously at a single closing, then the combined transactions would be identical to the Recapitalization in all respects—both in substance and in form. Analyzed that way, the Recapitalization would be governed by Tri-Star/Rossette, because Regency's de facto controlling stockholder (Ponsoldt/Statesman) would have: (1) caused Regency to engage in a transaction that, by means of a stock issuance, resulted in the controller expropriating for himself, economic value and voting power from, and to the corresponding detriment of, the public shareholders; and then (2) transferred that majority stock interest to a third party — Levy/Royalty—after having monetized that controlling interest by receiving (through Statesman) all but $750,000 of the $4.75 million cash proceeds of the Recapitalization.
The question, as we view it, is whether because these two component transactions were timed to occur simultaneously rather than sequentially, Regency's public shareholders should lose their entitlement, under Tri-Star/Rossette, to seek redress in a direct action. We think not. To do so would unjustly exalt form over substance in circumstances where the identical policy concerns that underlie Tri-Star and Rossette exist here.31
It is the very nature of equity to look beyond form to the substance of an arrangement.32 "Equity will not permit one to evade the law by dressing what is prohibited in substance in the form of that which is permissible."33 So too, equity will not permit a fiduciary to deprive his beneficiaries of their entitlement to seek direct redress for fiduciary misconduct by structuring a transaction so as to obscure that entitlement. Although this case differs from Rossette in transactional form, the underlying concerns and substantive effects that justify recognizing an entitlement to sue directly are the same.
In this case, as in Tri-Star and Rossette, the fiduciary exercises its stock control to expropriate, for its benefit, economic value
[925 A.2d 1281]
and voting power from the public shareholders. In the classic Tri-Star/Rossette paradigm, the ultimate transferee and beneficiary of the expropriation is the fiduciary. Here, the ultimate transferee is a third party, with the controlling stockholder being an intermediary that transfers the benefits of its expropriation to the ultimate beneficiary in exchange for cash or other equivalent value.
That is how equity views the Recapitalization, despite the fact that as a matter of form, the Recapitalization consisted of two transactions that occurred simultaneously, with the result that to an outside observer, the controlling stockholder never held the benefits of the expropriation for any length of time that the naked human eye could discern. In our view, that difference in form, which is a product of transactional creativity, should not affect how the law views the substance of what truly occurred, or how the public shareholders' claim for redress should be characterized.34 In both cases the fiduciary exercises its control over the corporate machinery to cause an expropriation of economic value and voting power from the public shareholders. That the fiduciary does not retain the direct benefit from the expropriation but chooses instead to convert that benefit to cash by selling it to a third party,35 is not a circumstance that can justify depriving the injured public shareholders of the right they would otherwise have to seek redress in a direct action.
Accordingly, we conclude that although the Court of Chancery correctly determined that the Recapitalization claim could be brought derivatively, it erred in concluding that that claim was exclusively derivative.