Founders and majority stockholders who wish to raise capital by issuing additional stock may want to do so without relinquishing majority voting power, even after they no longer hold a majority of the corporation’s shares. They can maintain control by reclassifying the corporation’s stock so that that the controller’s stock has superior voting rights, often 10 times that of the common shares. Earlier this year, Facebook’s Mark Zuckerberg, who already held super-voting shares, proposed a plan under which newly issued shares would have no voting rights. Although similar plans had been successfully implemented by Alphabet (Google’s parent) and Snap Inc. (formerly Snapchat, Inc.), the Facebook plan was withdrawn in the face of litigation brought by the company’s stockholders in the Delaware Court of Chancery.
Another company that successfully reclassified its shares is NRG Yield, Inc., a Delaware corporation that owns a portfolio of income-producing assets in the energy generation and infrastructure fields. Its majority stockholder, NRG Energy, Inc., initially held 65% of the company’s stock, but the issuance of additional equity reduced its control to about 55%, and further equity sales would have eliminated NRG Energy’s majority control in a relatively short period. In May 2015, NRG Yield effected a stock reclassification under which new Class C and D shares were issued with only one one-hundreth of the voting power of the outstanding Class A and B shares. Because any new equity holders would have much lower voting power, NRG Energy would maintain its control of the vote much longer. The reclassification was negotiated and approved by a committee of independent directors and was conditioned on approval by a majority of stockholders unaffiliated with the controller.
In September 2016, an NRG Yield stockholder filed a class-action complaint in the Delaware Court of Chancery alleging that the company’s directors and NRG Energy as its controlling stockholder breached their fiduciary duties by approving the reclassification, based on the theory that NRG Energy received a benefit not shared with other stockholders by “perpetuating” its control of NRG Yield. In IRA Trust fbo Bobbie Ahmed v. Crane, 2017 Del. Ch. LEXIS 843 (Del. Ch. Dec. 11, 2017), Chancellor Andre G. Bouchard found that although NRG Energy did receive a unique benefit, which would make the transaction subject to the stringent entire fairness standard of review, the approval of a committee of independent directors and the fully informed, uncoerced vote of a majority of the minority stockholders made the transaction subject to the defendant-friendly business judgment standard of review, and required dismissal of the complaint.
The Court applied the “MFW” standard established by the Delaware Supreme Court in Kahn v. M&F Worldwide Corp., 88 A.3d 635 (Del. 2014). Under MFW the business judgment standard applies to a conflicted transaction if six elements are present:
(i) the controller conditions the procession of the transaction on the approval of both a Special Committee and a majority of the minority stockholders; (ii) the Special Committee is independent; (iii) the Special Committee is empowered to freely select its own advisors and to say no definitively; (iv) the Special Committee meets its duty of care in negotiating a fair price; (v) the vote of the minority is informed; and (vi) there is no coercion of the minority.
88 A.3d at 645. MFW involved a merger transaction. The Court in Crane rejected the plaintiff’s argument that the MFW standard should apply only to mergers, stating “I see no principled reason why that rationale would not apply equally to other conflicted controller transactions.”
Crane represents a step in the “evolution” of the MFW doctrine, making it clear that the standard is not limited to mergers, but also provides a roadmap for other conflicted transactions with controlling stockholders. Specifically, in the case of stock reclassifications that prolong or perpetuate a majority stockholder’s control, a Delaware corporation can ensure favorable review if the transaction is conditioned from the outset on the approval of a special committee of independent directors with a mandate that allows it to freely select its own legal and financial advisors, to meet its duty of care in negotiating with the majority stockholder, and to definitively say no, and on the informed, uncoerced vote of a majority of the minority stockholders.
James G. (Jay) McMillan is a partner in the Wilmington, Delaware office of Halloran Farkas + Kittila LLP. He concentrates his practice in complex corporate and commercial matters, with a particular focus on litigation in the Delaware Court of Chancery. For more information on the firm, visit hfk.law.
