Delaware Supreme Court Issues Decision on the Direct Nature of “Holder Claims”

On May 24, 2016, the Delaware Supreme Court, sitting en banc, issued an opinion in Citigroup Inc. v. AHW Investment Partnership, No. 641, 2015, in response to a question certified by the U.S. Court of Appeals for the Second Circuit.  The issue before the Court related to whether stockholders of a Delaware corporation can assert direct claims for damages for a stock’s loss of value after opting to hold their shares in reliance upon the corporation’s alleged misstatements.  While the Court’s opinion (a copy of which may be accessed here) specifically addressed the nature of so-called “holder claims,” it also offered guidance on how the Court views the distinction between direct and derivative causes of action available to stockholders – the latter of which require factual allegations demonstrating that pre-suit demand upon the board of directors would be futile.

The plaintiffs were owners of Citigroup stock who at one time held 17.6 million shares valued at $35 per share in 1998.  In May 2007, the plaintiffs developed a plan to liquidate their Citigroup stock and sold one million shares at $55 per share.  After this initial sale, however, they decided to hold their remaining shares based on Citigroup’s public filings and financial statements - documents the plaintiffs allege did not disclose Citigroup's true exposure to subprime mortgage risks, which later caused the company’s stock price to plummet.  The plaintiffs ultimately sold their remaining stock in March 2009 for $3.09 per share, after three more occasions when they declined to sell at a higher price in reliance upon Citigroup’s public statements.

The plaintiffs then filed a complaint against Citigroup and certain of its directors and officers in the U.S. District Court for the Southern District of New York, alleging that the decision to retain their shares - rather than sell them for a much higher price than they ultimately received - resulted from Citigroup’s failure to disclose accurate information about its true financial condition.  The complaint asserted claims for fraud and negligent misrepresentation under Florida law and sought damages equal to what the plaintiffs would have realized had they sold 16.6 million shares at $55 per share in May 2007 rather than at $3.09 in March 2009. 

The District Court granted the defendants’ motion to dismiss for failure to state a claim, while nonetheless finding that the plaintiffs’ claims were direct, rather than derivative, under the Delaware Supreme Court’s holding in Tooley v. Donaldson, Lufkin & Jenrette, Inc., 845 A.2d 1031 (Del. 2004).  (Tooley held that a stockholder’s claim will be characterized as derivative or direct based on whether the corporation or the stockholder “suffered the alleged harm” and “would receive the benefit of any recovery or other remedy,” 845 A.2d at 1033.)  When the plaintiffs appealed the dismissal to the Second Circuit, Citigroup cross-appealed the District Court’s ruling that the plaintiffs alleged direct claims.  The Second Circuit, after determining that the issue was governed by the law of Delaware (Citigroup’s state of incorporation), then asked the Delaware Supreme Court to decide whether the plaintiffs’ “holder claims” were derivative or direct.

The Court answered this question by stating that the plaintiffs “may assert their Holder Claims against Citigroup directly if those claims are otherwise cognizable.”  Citigroup, p. 24.  This analysis, however, did not apply Tooley, as the Second Circuit had presumed; rather, the Court found the claims to be direct “because they belong to the holders and are ones that only the holders can assert, not claims that could plausibly belong to the issuer corporation.”  Id.  The Court noted that “determining whether a claim is direct or derivative depends on the nature of the claims itself,” and that Tooley and its progeny are limited to “the distinct question of when a cause of action for breach of fiduciary duty or to enforce rights belonging to the corporation itself must be asserted derivatively.” Id., p. 25 (quoting NAF Holdings, LLC v. Li & Fung (Trading) Ltd., 118 A.3d 175, 176 (Del. 2015)) (emphasis added).  As the Court further explained:

“Because directors owe fiduciary duties to the corporation and its stockholders, there must be some way of determining whether stockholders can bring a claim for breach of fiduciary duty directly, or whether a particular fiduciary duty claim must be brought derivatively on the corporation’s behalf.  We established Tooley’s two-pronged test as a means of determining whether such claims are direct or derivative. … [W]hen a plaintiff asserts a claim based on the plaintiff’s own right, such as a claim for breach of a commercial contract, Tooley does not apply.”

Id., p. 27 (footnotes omitted).  Since the plaintiffs’ common law fraud and negligent misrepresentation claims did not seek to enforce fiduciary duties or rights belonging to Citigroup, neither Delaware law nor Tooley was implicated.  Instead, the Court looked to Florida law (cited by the plaintiffs) and New York law (applied by the District Court) in concluding that the claims assert individual rights of the plaintiffs:

“That the holder claims under both New York and Florida law belong to the holder, not the issuer, alone is enough to make the [plaintiffs’] Holder Claims direct.  Delaware law cannot convert a direct claim that another state’s law has granted to securities holders by deciding that it actually belongs to the corporation that the securities holder is suing.  Thus, because the Holder Claims here could not possibly belong to the corporation, Delaware law has nothing to do with what type of claims the [plaintiffs] are asserting.”

Id., pp. 27-28 (footnotes omitted).

Apart from its discussion of holder claims, the Court’s opinion is instructive because it further refines an area of Delaware law – the distinction between derivative and direct stockholder claims – that traditionally has evaded precise application.  In particular, the Court re-emphasized that questions of harm and remedy under Tooley are not addressed until a preliminary inquiry about the nature of the claim is answered – does the stockholder seek to enforce rights belonging to the corporation or arising from the directors’ fiduciary duties?  If that answer is “no,” Citigroup suggests that the stockholder’s claim is direct and does not raise issues of demand futility.

Wilks, Lukoff & Bracegirdle, LLC represented an amicus curiae in the Citigroup appeal.  The foregoing views are solely those of the author and do not necessarily reflect the views of the firm or its clients.


Delaware Court of Chancery Revisits Tax-Affecting Pass-Through Entities In Statutory Appraisals

Compared to a C Corporation, an S Corporation offers tax benefits to its individual stockholders since it does not pay corporate income taxes on its earnings; rather, the taxes are “passed through” to the S Corporation’s stockholders, who pay personal income taxes on the earnings distributed to them. In this way, an S Corporation stockholder avoids “double taxation” on a C Corporation’s earnings – i.e., the corporate income tax paid by the entity and the tax paid by the individual stockholder on dividends issued from post-tax earnings.

The Delaware Court of Chancery has considered only rarely how these tax savings should be quantified when valuing shares of an S Corporation in an appraisal proceeding brought pursuant to Section 262 of Delaware’s General Corporation Law, 8 Del. C. § 262. The Court’s most recent opportunity arose in Owen v. Cannon, a post-trial opinion issued on June 17, 2015. (The Court’s full Memorandum Opinion may be accessed here.) In the course of appraising shares of an S Corporation in Owen, Chancellor Andre G. Bouchard utilized a tax-affecting method first adopted by the Court nine years earlier in Delaware Open MRI Radiology Associates, P.A. v. Kessler, 898 A.2d 290 (Del. Ch. 2006). The Owen ruling confirms that, when the Court of Chancery is asked to value shares of a Delaware S Corporation, it will include within the entity’s fair value an estimate of the “pass-through” tax savings realized by stockholders.

In Kessler, then Vice Chancellor Leo E. Strine, Jr. (now Chief Justice of the Delaware Supreme Court) analyzed in detail whether and how to account for an S Corporation’s tax advantages when appraising the enterprise’s fair value. At trial, the plaintiffs’ expert opined that no taxes should be deducted from the S Corporation’s projected earnings when performing a discounted cash flow analysis, thus producing a higher valuation. By contrast, the defendants’ expert deducted corporate-level income taxes from projected earnings as if the entity was a C Corporation, naturally resulting in a lower valuation. Ultimately, the Court concluded that “neither of the experts has taken the most reasonable approach,” and created its own method to estimate the benefits from “the favorable tax treatment that accompanies S corporation status.” 898 A.2d at 326-27. In the Court’s view, this approach was consistent with Delaware law recognizing that an appraisal petitioner is “entitled to be paid for that which has been taken from him.” Id. at 327 (quoting Tri-Continental Corp. v. Battye, 74 A.2d 71, 72 (Del. 1950)).

Specifically, the Kessler Court attempted “[t]o capture the precise advantage of the S Corporation structure” by “us[ing] a method that considers the difference between the value that a stockholder … would receive in [the entity] as a C corporation and the value that a stockholder would receive in [the entity] as an S corporation.” Id. at 327. This was done by comparing the hypothetical gains realized by a stockholder on distributions made by the entity as a C corporation and as an S Corporation. See id. at 329-30. The Court then computed an effective corporate tax rate for the S Corporation by determining the percent of earnings that would be deducted at the entity level to generate the same amount realized by the individual stockholder if the after-tax distribution was taxed a second time at the dividend rate. See id. at 330. In Kessler, this resulted in an effective corporate tax rate of 29.4% (compared to 40% for a C corporation), which the Court then applied to projected earnings in its DCF analysis. See id.

Eight years later, the Court of Chancery (albeit in the context of an entire fairness claim rather than statutory appraisal) adopted a DCF valuation which, following the method used in Kessler, applied to an S Corporation’s projected cash flows a hypothetical “pre-dividend tax rate” of 28.8%. Zutrau v. Jansing, 2014 WL 3772859, at *36 (Del. Ch. July 31, 2014). It was not until Owen, however, that the Court revisited the tax-affecting issue in more detail. In ruling on a plaintiff’s appraisal claims arising from the cash-out merger of an S Corporation, Chancellor Bouchard followed the same reasoning as Kessler, noting that “[a] critical component of what was ‘taken’ from [plaintiff] in the Merger was the tax advantage of being a stockholder in a Subchapter S corporation.” Owen, p. 56. The Court then concluded, consistent with Kessler and Zutrau, that “the Company’s earnings should be tax affected in order to perform a DCF valuation that adequately compensates [plaintiff] for being deprived of his Subchapter S stockholder status.” Id. The Court considered and rejected the defendants’ argument that an S Corporation’s stockholder should not receive the benefit of tax savings on earnings that the corporation retains and reinvests, rather than distributes, stating that:

"[T]he operative metric under the Kessler-based valuation method is not the actual distributions made by a Subchapter S corporation, but the amount of funds that are available for distribution to stockholders. To conclude otherwise would run afoul of the rationale of Tri-Continental Corp. because [plaintiff] would be deprived of ‘his proportionate interest’ in [the corporation] as a ‘going concern,’ which includes the Subchapter S corporation benefits that inure to earnings that are distributed and retained."

Id., pp. 58-59. Following the Kessler method, the Court calculated the S corporation’s effective entity-level tax rate to be 22.71%. See id., p. 60.

The Owen decision demonstrates that the Court of Chancery will continue to follow Kessler’s “hybrid” approach (as courts in other jurisdictions have done – see id., p. 57 n.265) to estimate the effective tax rate that should be applied to an S Corporation’s projected earnings, even though that entity does not pay corporate taxes in reality. At the same time, Owen re-affirms that the Court, in appraising an S Corporation’s shares, will include the value of tax benefits realized by a stockholder but eliminated through a merger. While the Court has not yet opined on the issue, presumably the same reasoning would apply when litigants seek to value other “pass-through” entities such as Delaware limited liability companies.

The foregoing views are solely those of the author and do not necessarily reflect the views of Wilks, Lukoff & Bracegirdle, LLC or its clients.

Delaware Supreme Court Adopts Rapid Arbitration Rules

The Delaware Rapid Arbitration Act, which was enacted and signed into law in April of this year, became effective on May 2, 2015. By its very language, the Act is intended “to give Delaware business entities a method by which they may resolve business disputes in a prompt, cost-effective, and efficient manner, through voluntary arbitration conducted by expert arbitrators, and to ensure rapid resolution of those business disputes.” 10 Del. C. § 5802. (The full text of the DRAA – Title 10 of the Delaware Code, Chapter 58 – may be accessed here.) It does so by authorizing parties to a dispute, so long as one of them is a business entity formed under Delaware law or with its principal place of business within Delaware, to enter into a written agreement to submit their dispute to arbitration. See 10 Del. C. § 5803(a). The written agreement must be governed by Delaware law and must contain an express reference to the DRAA. If the parties execute a qualifying agreement, they are deemed to have waived their rights to enjoin the arbitration and to challenge an arbitrator’s interim rulings or final order, except through the procedures set forth in the Act. See 10 Del. C. § 5803(c). These procedures allow the parties, among other things, to seek the Delaware Court of Chancery’s assistance in appointing an arbitrator (see 10 Del. C. § 5805) and – unless their agreement provides otherwise – to appeal an arbitrator’s final award directly to Delaware Supreme Court (see 10 Del. C. § 5809). The final award must be issued within 120 days after the arbitrator is appointed (see 10 Del. C. § 5809(b)), with the arbitrator’s fees reduced (and potentially eliminated) if the arbitrator fails to meet this deadline (see 10 Del. C. § 5806(b)).

On June 17, 2015, the Delaware Supreme Court adopted the Delaware Rapid Arbitration Rules to govern the proceedings in arbitrations initiated and conducted under the DRAA. (The full text of the Rules may be accessed here.) The Rules make clear that arbitrations conducted pursuant to the Act are confidential; accordingly, unless the parties agree otherwise, no documents or communications submitted in connection with an arbitration may be disclosed publicly or through any judicial or administrative proceeding. See Rule 5. (In the event a party appeals a final award to the Delaware Supreme Court, documents submitted through the appeal “shall become part of the public record only to the extent required by the Rules of that Court or by order of that Court.” Id.) The Rules also describe the scope of an arbitrator’s authority (see Rule 6) and grant the arbitrator immunity from giving testimony in a judicial or administrative proceeding and from civil liability arising from the arbitration (see Rule 7).

The Rules also establish procedures to govern various aspects of arbitrations conducted under the DRAA, including:

  • Commencement of an arbitration (Rule 9);
  • Service and timing of pleadings (Rule 12);
  • Contents of pleadings, such as claims, counterclaims and affirmative defenses (Rule 14);
  • Amendments to pleadings, with the arbitrator’s consent (Rule 15);
  • Discovery between the parties, described as an "exchange of information" (Rule 17);
  • Third party discovery (Rule 18); and
  • Pre-hearing disclosure of witnesses and exhibits (Rule 19).

The Rules limit the arbitration hearing to one day – unless the parties or the arbitrator determine that a different duration is appropriate – and afford the arbitrator discretion to determine the order of proof and procedures for submission of witness testimony and evidence. See Rule 22. The arbitrator shall include within a final award an allocation of fees and costs (including the expenses incurred by the arbitrator and the arbitrator’s counsel, if any), but shall not include attorneys’ fees paid by the parties. See Rule 25.

Finally, the parties may agree in writing – with the arbitrator’s consent – to modify or supplement the Rules so long as the modifications are not inconsistent with any provision of the DRAA. See Rule 3.

Please contact one of our attorneys if you or your business organization have any questions concerning the DRAA or the Rapid Arbitration Rules recently adopted by the Delaware Supreme Court.