May 9, 2016 | Fund Forum

"Control" and "Independence" in Minority Investments

4 min

A recent case involved a challenge to a proposed issuance of equity by a portfolio company (the Company) initiated by its largest stockholder, a private equity firm (the Firm). The plaintiffs in this case, a group of minority stockholders in the Company (the Plaintiffs), alleged that the transaction essentially amounted to a "squeeze-out merger" diluting their interests in the Company (the Transaction). Among other things, Plaintiffs alleged that the Firm breached its fiduciary duty, as a controlling stockholder, to minority investors (Count I). Defendants filed a motion to dismiss the complaint. The Court's ruling on the motion with respect to Count I underscores the nuances in the definition of "control" in a minority stockholder context and highlights the importance of electing truly independent directors.

In the years prior to this case, the Firm acquired a 26% equity stake in the Company and assumed a large position as a debt holder in the Company. At no time did the Firm's equity ownership of the Company exceed 26%; however, the Firm did possess significant contractual rights, which included the right to block financings and a veto right on any voluntary bankruptcy of the Company. The Firm proposed the Transaction, which would increase its equity position and dilute minority stockholders, prompting Plaintiffs to initiate this litigation to challenge the Transaction.

The Court initially articulated the standard of review with respect to a motion to dismiss. The Court stated that the business judgment rule establishes a presumption in favor of company directors, but indicated that, when the business judgment rule is rebutted, "entire fairness" becomes the applicable standard. Once the "entire fairness" standard is triggered, the Court will inquire into the related concepts of "fair dealing" and "fair price."

The Court stated that "[a] stockholder is controlling, and owes a fiduciary duty to other stockholders, 'if it owns a majority interest in or exercises control over the business affairs of the corporation'." The Court found that it was reasonably conceivable that the Firm, although a non-majority stockholder, was a controller of the Company because "a majority of the Board was not independent or disinterested, but rather was under the influence of, or shared a special interest with, [the Firm]" with respect to the Transaction. The Court concluded, therefore, that the Firm was a controlling stockholder at the time of the Transaction and denied defendant's motion with respect to Count I.

More specifically, in analyzing the independence of the Company's Board, the Court identified two items establishing control: (1) the personal financial benefit to certain directors of the Company (who were affiliated with the Firm) as a result of the Transaction that differed from the benefit to the Company stockholders generally; and (2) the Chief Executive Officer was faced with a "Morton's Fork:" (i) vote in favor of the Transaction; or (ii) vote against it, which potentially could result in the collapse of the company and the loss of the CEO's employment.

Subsequent to this ruling, private equity funds holding minority positions in portfolio companies ought to consider that:

  • When the business judgment of directors is rebutted, courts will impute an entire fairness standard with respect to a transaction. As a result, the controller would have the burden of proving that the price and process of a proposed transaction were fair to all stockholders.
  • Calculation of a fund's equity ownership in its portfolio company is not the only factor in a court's determination regarding whether such fund controls the portfolio company.
  • When designating fund directors for a portfolio company, even in a minority context, a fund or its sponsor should consider the extent to which such designee would be considered by a court to be independent and disinterested in transactions involving the stockholder and the company.
  • Courts may rely on disclosures and/or statements about the independence or disinterestedness of directors with respect to transactions involving stockholders and the company. The Court's finding here that certain directors were not disinterested was based, in part, on the Company's own disclosure that these directors, based on their affiliation with the Firm, had an interest in the transaction.