Private Equity

50/50 ownership and control of a portfolio company is almost always fraught with peril. This is particularly true in the corporate context when there was a failure to plan for, and provide appropriate mechanisms in a shareholders’ agreement for resolving, the inevitable deadlock that will occur when the equal owners/controllers are divided on the correct course of action for the company at some point in the future. A recent Delaware Court of Chancery decision, Coster v. UIP Companies, Inc., 2022 WL 1299127 (Del Ch. May 2, 2022), provides an illustration of these perils, as well as the limited means available to a board for resolving a deadlock when no contractual mechanisms have been put in place between the shareholders at the outset of the parties decision to engage in a business involving 50/50 ownership and control. The court’s decision also provides important guidance, assuming there is no further clarification from the Delaware Supreme Court, as to how to apply the sometimes vague standards that govern actions taken by a board, which are legally valid, but which are nonetheless alleged to have been undertaken for “inequitable purposes,” or in good faith but with a disenfranchising effect, without a “compelling justification.”

Coster involved a dispute among the shareholders of UIP Companies, Inc. UIP was formed by three entrepreneurs. Each owned 33-1/3rd of the issued shares initially. The original board of UIP consisted of five seats held by five individuals—one seat each for the original three shareholders and two additional seats for specifically named employees of UIP, Cox and Bonnell. At some point, one of the original owners resigned from the board and tendered his shares back to UIP. As a result, the two remaining shareholders, Wout Coster and Steven Schwat, then each owned 50% of the issued and outstanding shares. But there was no effort made to replace the now vacant director seat; thus the remaining directors were Wout, Steven and the two original employees. Then Wout died, and his spouse, Marion, inherited his shares. But the only directors at that point were the remaining three directors—Steven and the two employees, one of whom, Bonnell, was considered crucial to UIP’s viability as a going concern. In other words, two board seats remained vacant and the shareholders had not acted to fill those vacancies.

Following Wout’s death, and in keeping with the apparent wishes of Wout, considerable efforts were made to buy-out Marion. But according to the court, her demands were considerably in excess of the valuation done by UIP (apparently 30 times the company’s equity value). Marion then called a shareholders meeting to elect new directors, but Steven and Marion deadlocked on every iteration of new board composition. That deadlock was then used a basis for a complaint that was filed by Marion seeking to appoint a custodian to have full control of the Company (the Custodian Action). Apparently, the appointment of a custodian would have had a devastating impact on UIP because UIP’s revenue producing contracts would have become subject to termination by the counterparties, thus threatening the continued viability of UIP.

The board of UIP, consisting of Steven, Bonnell and Cox, then determined to implement a strategy that would moot the Custodian Action and the leverage that Marion was presumably attempting to exert in order to force a buyout of her shares “at price detrimental to the Company.” That strategy involved the board agreeing to issue new shares of the Company (equal to 1/3 of the total outstanding shares), from authorized but unissued shares, to Bonnell (which had apparently long been promised to him given his importance to the Company), at a price based upon UIP’s valuation of the Company. The effect of the new issuance of shares to Bonnell (the Stock Sale), “to reward and retain an essential employee,” was to dilute both Steven’s and Marion’s 50/50 ownership, such that control was now vested in either Steven and Marion voting together in favor of a matter, or Bonnell, plus either Steven or Marion, voting in favor of a matter. In other words, Marion could no longer block actions as long as Steven and Bonnell voted in favor of them. Similarly, Steven could no longer block actions as long as Marion and Bonnell voted in favor of them.

With the Custodian Action thus mooted (because there was no longer a deadlock), Marion then sued to have the Stock Sale declared invalid. At the original trial of Marion’s action, then Vice Chancellor, now Chancellor, McCormick determined that the validity of the Stock Sale had to be judged under an entire fairness standard, principally because at least two of the three directors making that decision were interested in the transaction—Steven as the 50% owner who avoided the deadlock with Marion by virtue of the Stock Sale to Bonnell and Bonnell as the recipient of the shares sold. But even under that exacting standard, then Vice Chancellor McCormick determined, in the original trial of this dispute, that the Stock Sale had been entirely fair.^[1]

On appeal to the Delaware Supreme Court, the court reversed then Vice Chancellor McCormick’s original trial decision and remanded the case to the Court of Chancery for further proceedings. According to the Delaware Supreme Court, then Vice Chancellor McCormick had impermissibly ended her inquiry into whether there had been a breach of fiduciary duty by the board by confining her inquiry to the entire fairness review. Instead, according to the Delaware Supreme Court, “the court should have considered [Marion’s] alternative arguments that the board approved the Stock Sale for inequitable reasons, or in good faith for the primary purpose of interfering with [Marion’s] voting rights and leverage as an equal stockholder without a compelling reason to do so.”^[2] In other words, the board’s motives needed to be examined under Schell v. Chris-Craft Indus., Inc., 285 A.2d 437 (Del. 1971) and Blasius Indus., Inc. v. Atlas Corp., 564 A.2d 651 (Del. Ch. 1988): “After remand, if the court decides that the board acted for inequitable reasons or in good faith but for the primary purpose of disenfranchisement without a compelling justification, it should cancel the Stock Sale and decide whether a custodian should be appointed for UIP.”^[3]

There is nothing surprising about the concept of an equitable review of otherwise legal actions taken by a board in Delaware. After all, Delaware has long held that “inequitable action does not become permissible simply because it is legally possible[; and] [u]nder Delaware law, ‘director actions[s] [are] ‘twice tested,’ first for legal authorization, and second [for] equity.”^[4] But in the recent Coster decision, on remand, Chancellor McCormick appears to suggest that the confusing and vague standards for testing for “equity” in this context may be in need of some revisiting by the Delaware Supreme Court.

On remand, Chancellor McCormick first reviewed the “standards” articulated by Schnell (which declares invalid board actions taken for “inequitable purposes”) and noted that Schnell provides little guidance as to what is included in the universe of purposes that could be considered “inequitable.” This is particularly troublesome given the “potentially harsh consequences of it application.” She also commented that the Delaware Supreme Court had previously cautioned that Schnell should be applied “sparingly;” i.e., only in “those instances that threaten the fabric of the law, or which by an improper manipulation of the law, would deprive a person of a clear right.” She then noted that “Blasius must be interpreted as a carve-out to Schnell for disenfranchising actions taken in good faith” because Blasius distinguished between “disenfranchising actions that lack a good faith basis (and thus are per se prohibited under Schnell) and disenfranchising actions taken in good faith.” As a result, disenfranchising actions do not appear to necessarily always be actions taken for “inequitable purposes;” instead, board actions are inequitable only if they lacked a good faith basis. Thus, if the board has legitimate, as opposed to pretextual, justifications for a disenfranchising action then it well may be in good faith and outside the Schnell analysis.

Chancellor McCormick, therefore, interpreted Schnell, as only “applicable in the limited scenario wherein the directors have no good faith basis for approving the disenfranchising action.” But here, Chancellor McCormick concluded that the board’s decision “did not totally lack a good faith basis.” While the “board’s desire ‘to eliminate [Marion’s] ability to block shareholder action, including the election of directors, and the leverage that accompanied those rights’ was inequitable,” the “board was also motivated to advance the best interest of UIP … [and] sought to reward and retain an essential employee, to implement a succession plan that Wout had favored, and to moot the Custodian Action to avoid risk of default under key contracts.” Thus, according to Chancellor McCormick, “[t]o the extent a Schnell rule exists that requires a court to declare invalid disenfranchising action taken for an inequitable purpose, that rule does not apply here.”

But finding that there was some good faith basis for the board’s disenfranchising action still required a further review under the Blasius standard. And that review requires a “compelling justification” for a disenfranchising action taken by a board, even one taken in good faith. Here, Chancellor McCormick found that “the Custodian Action rose to the level of an existential crisis for UIP[, because] the appointment of a custodian could trigger broad termination provisions in key contracts and threaten a substantial portion of UIP’s revenue.” Moreover, “the board did not act for the primary purpose of protecting its incumbency.” Instead, the “board had significant business reasons for approving the Stock Sale[, and] [t]hose reasons provide a compelling justification for the UIP board’s action.” Therefore, Chancellor McCormick once again rejected Marion’s effort to invalidate the Stock Sale or have a custodian appointed.

How much easier would this have been if there had been a stockholders’ agreement in place that dictated a process for a buyout in the case of the death or divorce of a stockholder or otherwise provided for a buy-sell arrangement in the case of a deadlock. In the private equity world, the idea that there was no pre-agreed exit mechanic or a specific means of resolving deadlocks is almost inconceivable. But it does happen. Planning for death, divorce or changed business plans of your founder, who is retaining significant ownership in a portfolio company, should always be front of mind.