Chancery Court Denies Motion to Dismiss Fiduciary Duty Claims Where Directors Approved Merger That Extinguished Threatened Derivative Claims

Securities Litigation, Investigations & Enforcement Alert | August.04.2016

On July 28, 2016, the Delaware Court of Chancery held that stockholders of Riverstone National, Inc. had adequately stated a breach of fiduciary duty claim against the company's directors who approved a merger that extinguished threatened derivative claims against them.  See In re Riverstone Nat'l, Inc. S'holder Litig., C.A. No. 9796-VCG (Del. Ch. July 28, 2016).  The court concluded that the plaintiffs had sufficiently rebutted the business judgment rule and stated claims under "entire fairness" review because they alleged that a majority of Riverstone's directors had usurped a corporate opportunity by personally investing $4.65 million in other companies operating in Riverstone's general line of business, knew that Riverstone's shareholders were investigating potential derivative claims against them in connection with those investments, and nonetheless proceeded to negotiate a sale of the company for $94 million to an acquirer that agreed not to pursue any litigation against them, including, by implication, the threatened usurpation claims.  In re Riverstone is a cautionary reminder to directors that self-interested motives for negotiating mergers and other transactions will be subject to enhanced scrutiny, and may even lead to personal liability in the event directors are found to have acted disloyally to their shareholders. 

Background

In 2008, Riverstone—then a multi-family property management company—became interested in the single family home rental business.  At the time of the transaction at issue, Riverstone's majority stockholder was CAS Capital Limited, a company controlled by two of Riverstone's five directors, Nicholas and Peter Gould.  In March 2012, Riverstone formed an investment fund, which it pitched to institutional investors, including Blackstone Group LP.  Blackstone, in turn, agreed to "help execute" Riverstone's business plan, including by forming a limited partnership known as Invitation Homes.  Riverstone was allegedly integral to Invitation Homes's business, serving as property manager of its properties and advancing significant funds to develop the company.  Riverstone also assisted Blackstone in its development of another company, B2R, which provided residential buy-to-rent mortgages for large scale single family portfolio investors.  Even though Riverstone never received an ownership interest in Invitation Homes, all but one of its directors were given the opportunity to, and did, acquire a stake in the company.  In addition, the Goulds were offered ownership interests in B2R, and the Goulds and another Riverstone director were also offered, and took, executive positions at Invitation Homes and B2R.

On May 20, 2014, two of Riverstone's stockholders informed Riverstone that its directors and officers breached their fiduciary duties by usurping Riverstone's corporate opportunity to invest in Invitation Homes and demanded that all their equity interests in Invitation Homes be transferred to Riverstone.  The stockholders also sent two books and records demands to investigate this issue, and, after those demands were rebuffed, the stockholders filed suit in the Chancery Court under 8 Del. C. § 220.  That same day, Riverstone executed a merger agreement with Greystar Real Estate Partners, LLC, which had been approved by CAS, pursuant to which Riverstone's stockholders would receive cash equal to their pro rata share of the total $94 million purchase price, less certain adjustments based on Riverstone's debt at closing.  The merger agreement provided, inter alia, that Greystar would not pursue litigation against the directors, including, implicitly, any derivative claims arising out of their alleged usurpation of the Invitation Homes opportunity. 

The same stockholders that had brought the records demands then filed suit against Riverstone's officers and directors, alleging that they breached their fiduciary duties by, inter alia, usurping a corporate opportunity owed to Riverstone by investing in Invitation Homes.  The stockholders also alleged that CAS breached its fiduciary duties as Riverstone's controlling stockholder when, inter alia, it failed to obtain any value from the company for the usurpation of the Invitation Homes opportunity.  Finally, the stockholders alleged that Riverstone's directors and CAS breached their fiduciary duties because they intentionally misclassified $20 million in capital contributions from CAS as "debt due to affiliates" instead of equity in order to reduce the amount paid to Riverstone's stockholders in connection with the merger.  Vice Chancellor Glasscock held that the plaintiffs had alleged sufficient facts to rebut the business judgment rule and trigger "entire fairness" review, and held that the plaintiffs had adequately stated a breach of fiduciary duty claim against Riverstone's directors.  The Vice Chancellor did not address the claims against CAS because CAS did not move to dismiss the plaintiffs' claims.

Analysis

  • "Entire Fairness" review will likely apply where there are particularized allegations that a majority of directors negotiated a merger in order to extinguish threatened derivative claims against them.  The court agreed that the plaintiffs' allegations adequately rebutted the business judgment rule—and triggered "entire fairness" review—because they alleged that a majority of Riverstone's directors were not disinterested, as they orchestrated the merger with Greystone that extinguished a possible derivative action belonging to the company against them for usurpation, and thereby obtained a special benefit for themselves: relief from potential liability.
  • But Delaware courts will be wary of generalized allegations that directors entered into a merger to extinguish potential derivative claims against them.  Conclusory statements of such a motive will not suffice.  Rather, particularized allegations will be necessary to rebut the application of the business judgment rule.  The court explained that, "[i]f a conclusory allegation—that a potential derivative suit against directors existed, but was extinguished by a merger—was sufficient to show that directors were interested in the merger, much ground for strike suits and other mischief would be possible."  However, the court found that the Riverstone plaintiffs' allegations were sufficiently particularized to overcome the business judgment rule because: (i) they alleged sufficient facts to support a derivative claim for usurpation that would have survived a motion to dismiss; (ii) they alleged that the directors were aware, at the time they negotiated the Greystone deal, of the potential derivative action against them for usurpation given the plaintiffs' books and records demands; (iii) they alleged that the potential for liability was material to the directors; and (iv) they alleged that the directors nonetheless recommended an agreement that extinguished the potential claims against them by contract. 
  • Even where "entire fairness" review applies because the merger is alleged to have been entered into for the purpose of extinguishing derivative claims against the selling company's directors, stockholders will still have to allege sufficient facts tending to show that the transaction was not entirely fair in order to defeat a motion to dismiss.  The Riverstone plaintiffs alleged that the merger was not entirely fair because the $94 million sale price did not include the value of the extinguished derivative claims against Riverstone's directors, which the plaintiffs alleged were material.  The court found that this allegation was sufficient to plead that the merger was not entirely fair because the value of the extinguished usurpation claims—which were premised on the directors' investments in Invitation Homes totaling $4.65 million—was material given that it represented approximately 10% of the gross merger consideration net of post-closing adjustments.
  • The corporation itself is not a proper defendant on a fiduciary duty claim.  The plaintiffs named Riverstone as a nominal defendant because, even though they were not seeking to impose liability upon the company, they argued that inclusion of Riverstone as a defendant was necessary to ensure that complete relief was afforded, and, in any event, they wanted discovery from Riverstone.  The court dismissed the claims against Riverstone because, "[u]nder Delaware law, fiduciary duties are owed by the directors and officers of a corporation and not by the corporation itself," and therefore "Riverstone cannot be held liable for any of the claims pled by the Plaintiffs based in breach of fiduciary duty."
Breach of fiduciary duty claims based on alleged misclassification of company funds in connection with a merger are likely to fail absent coherent allegations that the classifications were inconsistent with historical practice and actually made in light of the merger.  The plaintiffs alleged that Riverstone misclassified CAS's capital contributions as "debts due to affiliates" when they should have been classified as equity, and that Riverstone's directors were motivated to engage in this misclassification because the base purchase price for the merger was reduced by Riverstone's outstanding indebtedness at the time of closing.  The court rejected these allegations because, among other things, "[a]bsent from the Complaint are facts indicating when the alleged Contributions were made; and whether the accounting treatment changed between the times the Contributions were made and the time of the Merger, or whether the change was made in light of the Merger."  The court also observed that the plaintiffs had failed to plausibly allege how they were harmed by the alleged misclassifications because, if the contributions had been classified as equity (as the plaintiffs contended they should have been), then CAS would have received stock, and it was "unclear, based on the facts alleged, that the Plaintiffs' share of the additional $20 million in merger consideration would have outweighed the dilution of the Plaintiffs' interest."