When Even “Entirely Fair” Is Not Enough

The Delaware Supreme Court recently reversed Chancellor Kathaleen S. McCormick’s post-trial decision upholding a disputed stock sale after concluding that the sale satisfied the entire fairness standard of review.  Although the Court affirmed the trial court’s entire fairness finding — Delaware’s most rigorous standard of review under which a defendant must establish that a transaction was the product of both fair dealing and fair price — it nevertheless reversed because the Court of Chancery concluded that entire fairness was the “end of the road” for judicial review and declined to consider the board’s motivations for the transaction.  Invoking the principle expressed in the seminal Delaware opinion in Schnell v. Chris-Craft that “inequitable action does not become permissible merely because it is legally possible,” the Supreme Court remanded the case for further consideration of the motivation for and purpose of the subject stock sale.

Coster v. UIP Companies, Inc. arose from a control dispute over UIP Companies, Inc.  (“UIP” or the “Company”).  Prior to the litigation, UIP was equally owned by Plaintiff Marion Coster and Defendant Steven Schwat.  Coster had long been seeking a buyout, but when that did not come to fruition she made several attempts to reduce or increase the size of the board in order to break a deadlock.  When those attempts failed, Coster commenced litigation seeking the appointment of a custodian to break the deadlock.

In response, UIP’s board — then comprised of Schwat and two directors aligned with him — voted to issue a one-third interest in UIP to director Peter Bonnell, based on a valuation conducted by an independent third party (the “Stock Sale”).  Coster then filed a second litigation in the Court of Chancery seeking to cancel the Stock Sale on the grounds that UIP’s board breached its fiduciary duties in approving it.

The Court of Chancery consolidated the two litigations and held a trial.  It made several factual findings, including that the Stock Sale was intended to dilute Coster, entrench the board, and moot the litigation in which Coster sought to appoint a custodian.  It also found that Schwat and Bonnell were interested in the transaction.  Nonetheless, applying the onerous entire fairness standard of review, the Court of Chancery concluded that the Board engaged in a fair valuation process and approved the Stock Sale at a fair price, relying upon, among other things, the independent valuation.  Having reached that conclusion, the Court of Chancery declined to consider Coster’s alternative arguments that the motivation and purpose of the sale was to impede her rights as a stockholder.

The Supreme Court affirmed the entire fairness determination.  The Supreme Court went on, however, to hold that the trial court nonetheless erred in “bypass[ing] a different and necessary judicial review where, as here, an interested board issues stock to interfere with corporate democracy and that stock issuance entrenches the existing board.”  Thus, while in a vacuum the sale process and price may have been fair, “inequitable action does not become fair just because it is legally possible.”

In particular, the Supreme Court held that the Court of Chancery should have assessed Coster’s arguments under Schnell (famed for the above-quoted point that what is legally permissible is not necessarily equitable) and Blasius Indus. v. Atlas Corp. (which requires that a defendant provide a compelling justification for actions taken for the “primary purpose of thwarting” the stockholder franchise).  Under these precedents, and notwithstanding the court’s conclusion that the transaction resulted from a fair process and produced a fair price, the Court of Chancery therefore should have cancelled the Stock Sale if (i) “the board approved the Stock Sale for inequitable reasons,” or (ii) if the board, acting in good faith (but without a compelling justification), “approved the Stock Sale for the primary purpose of thwarting Coster’s vote to elect directors or reduce her leverage as an equal stockholder.”  The Supreme Court remanded for the Court of Chancery to conduct further proceedings to address these issues and, if the answer to either question is affirmative, to cancel the stock sale.

Coster thus serves as an important reminder that, even where a board follows an appropriate process, and the result is “entirely fair” to the complaining stockholder, a court could still find that directors breached their fiduciary duties if they were motivated by inequitable reasons.  It also reaffirms Delaware’s commitment to the integrity of the stockholder franchise, the “ideological underpinning upon which the legitimacy of the directors managerial power rests.”  But Coster also leaves open questions.  Most importantly, as the Supreme Court footnoted, how Schnell and Blasius will “fit together in future cases” with other standards of review — most importantly, Unocal enhanced scrutiny.

This post is as of the posting date stated above. Sidley Austin LLP assumes no duty to update this post or post about any subsequent developments having a bearing on this post.