Coster v. UIP Companies, Inc.: Delaware Supreme Court Reminds That Entire Fairness Is Not A Ticket To Ride Where Critical Stockholder Rights Impaired

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A recent en banc opinion by the Delaware Supreme Court furnishes an important reminder that, in some transactional paradigms, discharging the dual evidentiary burdens of entire fairness (i.e., fair process and fair price) does not confer a “ticket to ride” upon a conflicted board animated principally by a desire to undermine the stockholder franchise.  And again the adage, “inequitable action does not become permissible simply because it is legally possible” moves to the fore.

Trial Court Disposition

Coster v. UIP Companies, Inc., et al., Del. Supr., No. 49, 2020, Seitz, C.J. (June 28, 2021), involved an appeal from a post-trial decision of the Court of Chancery.  In the action below, one of two equal stockholders (Plaintiff Marion Coster) in a multi-organizational real estate investment enterprise (“UIP”) filed an action under 8 Del. C. § 226(a)(1) seeking the appointment of a custodian to break a deadlock over the election of directors.  While parallel buy-out negotiations and special stockholder meetings to consider Coster’s various proposals to reconstitute the five-member board (including filling two board seats left vacant for years) continued, the board (consisting of the other 50% stockholder’s appointee (Defendant Steven Schwat) and two non-stockholder employees (Bonnell and Cox)) reduced the number of board seats to three by unanimous written consent.

The three-member board also retained an independent financial advisor to furnish a valuation of UIP.  With the valuation in hand, Schwat offered to sell Bonnell one-third of IUP’s authorized but unissued stock at one-third the valuation price.  Bonnell accepted and the board authorized the transaction by unanimous written consent.  The sale, of course, diluted Coster and broke the shareholder deadlock over board constituency, mooting the pending 226(a)(1) action.

In response, Coster filed a second action asserting direct and derivative fiduciary duty claims.  In particular, the second action sought to cancel the Bonnell stock sale and impose a constructive trust, and alleged that the dilutive stock sale had interfered with her voting rights and impeded her statutory right to seek the appointment of a custodian.  This action was consolidated with the first, and the two proceeded to trial.

At trial, the court found that the stock sale was significantly motivated by a desire to block Coster’s efforts respecting the election of directors and to moot her initial custodian action.  The court likewise found that Schwat and Burnell were “interested” in the transaction, and thus the sale was effected by a conflicted board.  Under established Delaware precedent, and given the absence of prophylactic process enhancements, the Defendants bore the burden of proving the entire fairness of the sale.

The trial court determined that, though sub-optimal, the process employed by the board was fair given, especially, the board’s reliance on a third-party valuation.  The court likewise determined that the sale price was fair, in that the valuation was credible and provided the most reliable indication of enterprise value.  Having determined that the stock transaction was entirely fair, the court declined to appoint a custodian and dismissed the action.  In particular, the court determined that because Delaware’s most onerous standard of scrutiny had been met, the Court could not then proceed to scrutinize the transaction under a lesser level of scrutiny to determine, as urged by Coster, whether the board had a “compelling justification” to take the action it did given its obvious impact on stockholder rights – or as argued by Coster, “in the context of stalled buyout negotiations, even though the board had the legal authority to issue IUP stock, the board could not act inequitably by approving the [stock sale] in order to dilute her ownership interest, defeat her voting and statutory rights, and entrench themselves.”  And this is where things get interesting.

Delaware Supreme Court’s Reversal and the Schnell/Blasius Test

On appeal, the Supreme Court found no fault with the trial court’s entire fairness determinations.  The Supreme Court did, however, find reversible error in the lower court’s decision to limit its inquiry to entire fairness.

The Supreme Court held: “In our view, the court bypassed 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.”  The Supreme Court analyzed a line of cases (foremost among them, Schnell v. Chris-Craft Industries, 658 A.2d 176 (Del. Ch. 1985), aff’d, 500 A.2d 1346 (Del. 1985) and Blasius Industries, Inc. v. Atlas Corp., 564 A.2d 651 (Del. Ch. 1988)) advancing the principle that a board of directors cannot escape judicial review under the cloak of mere legality; on the contrary, director actions are “twice-tested” for (1) legal authorization and, critically, (2) for equity.  Accordingly, “careful judicial scrutiny” is necessary where the stockholder franchise is frustrated or denied.  And where boards of directors deliberately employ legal strategies to undermine a shareholder vote, there “can be no dispute that such conduct violates Delaware law.”

The Supreme Court also clarified that while the bedrock principle articulated in Schnell (that the subversion of corporate democracy by manipulation of corporate machinery will not be countenanced under Delaware law) does not apply where the board acts in good faith, the Court of Chancery’s later decision in Blasius[1] teaches that if the board nonetheless acts for the “primary purpose” of impeding stockholder franchise rights, the board must prove a “compelling justification” for its actions.

Key Takeaways

• Actions taken by a conflicted board that technically are lawful but intended to undermine stockholder voting rights or other valuable statutory rights cannot be “sanitized” simply by meeting the dual fair process – fair price requirements of entire fairness; rather, such actions are subject to a further “compelling justification” inquiry (e., “Schnell/Balsius review”);
• Where the directors’ “primary purpose” was to thwart stockholder franchise rights, the “compelling justification” inquiry is to be undertaken before application of mid-tier judicial scrutiny, such as the reasonableness and proportionality test of Unocal Corp. v. Mesa Petroleum Co., 493 A.2d 946 (Del. 1985);
• While Coster v. UIP Companies, Inc. and the precedent it analyzes focus on directorial missteps, stockholders, too, are equally capable of using the powers lawfully at their disposal for purposes inimical to the best interests of the enterprise. Nothing in  Coster v. UIP Companies signals that the compelling justification test cannot be met under the right (though probably extraordinary) circumstances.  But where a conflicted board takes action for the purpose of entrenchment or otherwise undermining stockholder rights (foremost, voting rights), it should be preceded by some intensely introspective directorial soul-searching.

[1]   The standard of review articulated in Blasius later was approved by the Delaware Supreme Court in MM Cos., Inc. v. Liquid Audio, Inc., 813 A.2d 1118 (Del. 2003).