(Article from Securities Law Alert, October/November 2019)
For more information, please visit the Securities Law Alert Resource Center
On October 4, 2019, the Delaware Supreme Court affirmed the dismissal of a shareholder action premised on the legal theory that several venture capital firms constituted a “control group” that breached its fiduciary duties in connection with allegedly dilutive financing transactions and a subsequent acquisition. Sheldon v. Pinto Tech. Ventures, 2019 WL 4892348 (Del. 2019) (Valihura, J.).[1] Plaintiffs alleged, inter alia, that the venture capital firms (1) collectively controlled over 60% of the company’s shares, (2) were parties to a voting agreement that provided them with the right to appoint three directors, who in turn chose two additional directors; and (3) had a history of investing together. The Delaware Supreme Court found these allegations insufficient to demonstrate that the venture capital firms “were connected in a legally significant way, either before or during the allegedly dilutive actions.”
The court explained that Delaware law “recognizes that multiple stockholders together can constitute a control group exercising majority or effective control, with each member subject to the fiduciary duties of a controller.” The stockholders must be “connected in some legally significant way—such as by contract, common ownership, agreement, or other arrangement—to work together toward a shared goal.” The “mere concurrence of self-interest among certain stockholders” is not sufficient to establish the existence of a control group. “Rather, there must be some indication of an actual agreement, although it need not be formal or written.”
Plaintiffs argued that their allegations were similar to those in In re Hansen Medical Stockholders Litigation, 2018 WL 3025525 (Del. Ch. June 18, 2018). There, the Chancery Court held that plaintiffs adequately pled the existence of a “control group” by alleging, inter alia, that the stockholders had (1) coordinated their investments for twenty-one years, (2) declared themselves as a “group of stockholders” to the SEC; and (3) were “the only participants in a private placement that made them the largest stockholders of” the company at issue. But the Chancery Court in Sheldon found that plaintiffs’ allegations more closely paralleled those at issue in van der Fluitt v. Yates, 2017 WL 5953514 (Del. Ch. Nov. 30, 2017). In van der Fluitt, the court held plaintiffs failed to plead the existence of a “control group” where the defendant stockholders were not the only signatories of the relevant investor rights agreement, and that agreement did not concern the challenged transaction.
In Sheldon, the Delaware Supreme Court “agree[d] with the Court of Chancery that it is not reasonably conceivable that the [v]enture [c]apital [f]irms functioned as a control group.” 2019 WL 4892348. The Delaware Supreme Court noted that the voting agreement “bound all of [the company’s stockholders]” and “was unrelated” to the allegedly dilutive transactions. Moreover, the court observed that the agreement “only governs the election of certain directors to [the company’s board]” and “does not require [the stockholders] to vote together on any transaction.” The Delaware Supreme Court found similarly “unavailing” plaintiffs’ allegations concerning the venture capital firms’ prior investments. Plaintiffs pointed to four companies in which “two or more” of the venture capital firms “invested in the same financings.” The court observed that plaintiffs did “not identify any instance in which all three [v]enture [c]apital [f]irms participated in any investment,” or “allege that they held themselves out as a group of investors or that they reported as such to the SEC.” Instead, the “allegations merely indicate that venture capital firms in the same sector crossed paths in a few investments.”
[1] Plaintiffs argued that their failure to make a demand or plead demand futility did not mandate the dismissal of their claims because their claims were partially direct under Gentile v. Rosette, 906 A. 2d 91 (Del. 2006). In Gentile, the Delaware Supreme Court recognized that a claim may be “both derivative and direct in character” if “(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.”