Direct or Derivative Claims: Is “Brookfield” the End or Just the Beginning?
A Delaware corporation’s stockholder may bring an individual action to address unique injuries specific to his or her legal rights as a stockholder (a direct claim) or a suit on behalf of the corporation for harm done to the corporation (a derivative claim).
Despite this deceitfully unassuming threshold standing criterion, Delaware courts have often struggled to decipher what constituted a direct or derivative claim. The Delaware Supreme Court’s 2021 decision in Brookfield Asset Mgmt., Inc. v. Rosson helped clarify whether stockholders’ financial and voting rights, diluted through a transaction with a controlling stockholder, constituted direct or derivative claims.
Tooley test and Gentile’s carve-out
Prior to Brookfield, in 2004, the Delaware Supreme Court had announced a simplified test in Tooley v. Donaldson, Lufkin & Jenrette, Inc. to determine whether claims were direct or derivative, which centered on two questions: “(1) who suffered the alleged harm (the corporation or the suing stockholders, individually); and (2) who would receive the benefit of any recovery or other remedy (the corporation or the stockholders, individually)?”
Tooley’s test tracked the rationale in the Court’s 1988 decision in Kramer v. W. Pac. Indus., Inc. that “a court should look to the nature of the wrong and to whom the relief should go.” Two years later, however, the Court in 2006 provided a carve-out to Tooley in Gentile v. Rossette.
Relying on In re Tri-Star Pictures, Inc., Litig., the Gentile Court held that a stockholder, who allegedly suffered diluted economic and voting rights as a result of a transaction involving a controlling stockholder, had standing to pursue direct claims because such dilution/overpayment claims were “dual natured” (i.e., both direct and derivative).
Though all stockholders shared derivatively in the economic harm, the loss of voting rights constituted a unique harm suffered by the stockholders directly. Because of Gentile’s holding, this dual natured exception created palpable tension between it, Tooley, and their progeny — often proving difficult to apply — until Brookfield was decided 15 years later.
Delaware Supreme Court’s decision in Brookfield
In Brookfield, stockholders challenged a company’s private placement of stock to its controlling stockholder because the transaction allegedly diluted both the financial and voting interests of the minority stockholders. After the stockholders filed their complaint, the controlling stockholder acquired the company’s remaining shares in a merger.
The defendants moved to dismiss, arguing that dilution claims were “entirely derivative” under the Tooley test and that the stockholders lacked standing to bring derivative claims after a merger. Although the Court of Chancery agreed that the stockholders’ dilution/ overpayment claims were derivative under Tooley, it denied the motion to dismiss because the stockholders stated a direct claim under Gentile’s exception.
On interlocutory appeal, the defendants/appellants renewed their argument that the stockholders’ claims were derivative under Tooley and contended that Gentile should be overruled. The Delaware Supreme Court ultimately agreed and reversed the Court of Chancery’s decision, holding that “the corporation overpayment/ dilution Gentile claims ... are exclusively derivative under Tooley and that Gentile ... should be overruled.” The Court noted that the tension between Gentile and Tooley, Gentile’s superfluous “carve-out” given Revlon, Inc. v. MacAndrews & Forbes Hldgs., Inc., and the potential for double-recovery under Gentile warranted overruling it.
Nuances of Brookfield
The Court’s decision in Brookfield brought much needed clarity to the application of Tooley, both generally and to overpayment/ dilution claims in particular, and helped reconcile two divergent lines of cases, Tri-State and Kramer, by overruling the Court’s prior decision in Gentile. Yet, this newfound clarity opened the door to nuances that Brookfield did not address, particularly as to claims that do not neatly fit as dilution/overpayment claims.
Courts have begun to grapple with these nuances by focusing their analysis through Brookfield’s lens. This year, for instance, in In re MultiPlan Corp. S’holders Litig. (2022), the Court dealt with whether to characterize SPAC shareholders’ redemption rights claim as direct or derivative on a motion to dismiss. Citing Brookfield, the Court distinguished the redemption rights claim from a typical overpayment/dilution case because the harm — impairing stockholders’ ability to exercise their redemption rights — and the resulting damages would run to the stockholders, not the company. As a result, the Court held that the redemption rights claim was direct.
Brookfield also left open the possibility that dilution claims could still be considered direct claims under a Revlon analysis. Revlon, another bedrock Delaware case from 1986, provided that enhanced scrutiny applied to board decisions in three scenarios, as summarized by the Delaware Supreme Court’s decision in Paramount Commc’ns, Inc. v. QVC Network, Inc. (1994): (1) “when a corporation initiates an active bidding process seeking to sell itself or to effect a business reorganization involving a clear break-up of the company”; (2) “where, in response to a bidder’s offer, a target abandons its long-term strategy and seeks an alternative transaction involving the break-up of the company”; or (3) when approval of a transaction results in a “sale or change of control.”
Before Brookfield, the Court, when determining whether a claim was direct or derivative, noted in El Paso Pipeline GP Co., L.L.C. v. Brinckerhoff (2016) that “Revlon already accords a direct claim to stockholders when a transaction shifts control of a company from a diversified investor base to a single controlling stockholder.” Picking up on Brinckerhoff’s reference, the Brookfield Court specifically called out this third Revlon scenario to address harm that would be considered uniquely felt by stockholders who lost control through dilution.
In overruling Gentile, the Court provided that there was “no practical need for the Gentile carve-out” because “[o]ther legal theories, e.g., Revlon, provide a basis for a direct claim for stockholders to address fiduciary violations in a change of control context.” This was particularly true “when a transaction shift[ed] control of a company [from] a diversified investor base to a single controlling stockholder.” Thus, these types of Revlon claims appeared to remain direct claims under Brookfield.
Recently, the Court of Chancery has picked up on the invitation to review alleged dilution claims under the Revlon framework. In KZ Cap. Gen. Trading LLC v. Petrossov (2022), a plaintiff stockholder brought, among other things, a direct claim for “economic and voting power dilution” against the director defendants premised on their allegedly misleading disclosures surrounding an outsider’s investment in the company. The KZ Cap. Court, in denying defendants’ motion to dismiss, found, in the circumstances present there, the plaintiff had stated a direct claim under Revlon by pleading sufficient facts creating a reasonable inference that the disputed transaction shifted control from a diversified group to a single stockholder.
Although Brookfield is still in its infancy, the ripple effects have already begun to take root in Delaware law. Only time will tell how the courts will apply and interpret Brookfield when determining future creative claims seeking direct damages. Yet, if MultiPlan and KZ Cap. are any indication of things to come, Brookfield appears to have provided the courts with enough general guidance to make appropriate determinations on these issues thus far.
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Thomas W. Briggs, Jr. and Miranda N. Gilbert, “Direct or Derivative Claims: Is “Brookfield” the End or Just the Beginning?” Attorney Analysis, Reuters Legal News and Westlaw Today (March 22, 2022)
© 2022 Thomson Reuters. This article was first published on Reuters Legal News and Westlaw Today on March 22, 2022. These materials have been prepared solely for informational and educational purposes, do not create an attorney-client relationship with the author(s) or Morris, Nichols, Arsht & Tunnell LLP, and should not be used as a substitute for legal counseling in specific situations. These materials reflect only the personal views of the author(s) and are not necessarily the views of Morris, Nichols, Arsht & Tunnell LLP or its clients.