More often than not, the centerpiece of an intra-owner business dispute is a claim that those in control of the business breached their fiduciary duties to the company or the minority owners. While often easy to assert, the breach of fiduciary duty claim is subject to incredibly nuanced legal theories, including those surrounding agreed-upon conduct, safe harbors, conflicts of interest, business judgment, reasonable means, and different standards of review. Litigants often agree that a majority shareholder or director owes fiduciary duties to the company, then sharply disagree on what those duties are and how their conduct should be adjudged.
This week’s post takes us to the halls of Delaware Chancery Court, where a recent decision from Vice Chancellor Laster, In re Sears Hometown and Outlet Stores, Inc. Stockholder Litig., 2019-0798-JTL [Del Ch Jan. 24, 2024], offers a first-of-its-kind roadmap for assessing the fiduciary duties owed by a majority shareholder.
Sears Hometown and Sears Outlet, the Reorganization Plan.
Sears Hometown and Outlet Stores (the “Company”) is a small publicly traded company associated with Sears, Roebuck, and Co. In 2012, the Company had essentially two business segments. Sears Hometown consisted of approximately 500 stores that were much smaller than traditional Sears department stores and typically in rural markets. Sears Outlet stores were larger, and they sold discounted, refurbished, and scratch-and-dent merchandise from a variety of different manufacturers.
Former Sears CEO Eddie Lampert, through his investment funds, owned a majority of the Company’s outstanding shares. He was a traditionally passive owner; nobody from his funds sat on the Company’s board.
Between 2012 and 2018, it became clear that Sears Hometown was no longer profitable, especially after the bankruptcy of the Sears department stores. The Company’s board of directors appointed a special committee to explore their strategic options, and the special committee ultimately settled on a plan to liquidate Hometown and spinoff the Sears Outlet business (the “Reorganization Plan”).
Lampert did not like the Reorganization Plan. For one, it assumed that the Company could liquidate Hometown without facing serious legal exposure from its termination of their dealer agreements. Likewise, despite its modest growth, there was considerable debate about whether Sears Outlet—which lacked scale and a track record—could sustain that growth on its own.
The Controlling Shareholder’s Bid to Stop the Reorganization Plan.
By April 2019, it became clear that the Company was going ahead with the Reorganization Plan. So Lampert intervened. He took action by written consent of the majority of shareholders to (i) amend the Company’s bylaws to require that a liquidation receive approval from 90% of the board two times, at least 30 days apart, and (ii) remove two of the Board’s three directors and replace them with two outsiders. From Lampert’s standpoint, his shareholder action prevented a value-destroying mistake.
Having prevented the Reorganization Plan, Lampert negotiated and entered into an end-stage transaction with the Company that eliminated the minority shareholders’ interests in the Company.
V.C. Laster’s Shareholder Fiduciary Duty Roadmap.
A group of minority shareholders sued Lampert, alleging that he breached his fiduciary duties by intervening as the majority shareholder to thwart the Reorganization Plan. Those claims proceeded to trial in the Delaware Chancery Court. On January 24, 2024, V.C. Laster issued his post-trial opinion and order.
“[T]he most interesting conflicts in corporation law are engendered not by ‘bad guys’ seeking with guile to protect or advance private interests. The difficult and interesting questions arise from differing, but plausible conceptions of what constitutes right action in the circumstances,” began the Court’s decision.
V.C. Laster’s decision defines how the Court should judge Lampert’s actions as a controlling shareholder. He began with the fundamental precept that as an owner of more than 50% of the outstanding shares, Lampert owed fiduciary duties to the Company and the minority shareholders. But that was only the starting point. What are those duties, when are they implicated, and by what standard should Lampert’s conduct be judged?
For all those questions, the Court carefully charted a roadmap not previously seen in Delaware or New York law on fiduciary duties. At every fork in the road sits a different, well-reasoned fiduciary obligation and standard of review:
Stage One: Shareholder Stepping into the Boardroom vs. Shareholder Acting as a Shareholder.
Drawing a distinction not previously made in Delaware caselaw, V.C. Laster observed that there are two contexts in which majority shareholder action can implicate fiduciary duties, and different standards should apply to each.
First, where the controlling shareholder uses his influence to directly cause the corporation to act; effectively, where the shareholder himself enters the boardroom. In these cases, the controller becomes subject to the same fiduciary standards that apply to directors (see, e.g., Thorpe v Cerbco, Inc., CIV. A. 11713, 1995 WL 478954, at *8 [Del Ch Aug. 9, 1995]). Once a majority shareholder puts on a director’s hat, he or she assumes an obligation to act affirmatively to promote the best interests of the corporation.
Second, where the majority shareholder acts only at the shareholder level without stepping inside the boardroom, the Court held, “[a] controlling stockholder owes fiduciary duties when exercising stockholder powers, but not the same duties as a director owes.”
Stage Two: Shareholder Acting as a Shareholder to Preserve the Status Quo vs. To Change It.
Finding that Lampert’s conduct was solely related to the exercise of his shareholder-level rights—his right to vote on an amendment to the bylaws and to elect directors—V.C. Laster went further: the majority shareholder’s fiduciary obligations differ depending on whether the majority seeks to protect the status quo or upend it.
The Court reviewed several decisions surrounding the fiduciary obligations imposed on a shareholder’s right to vote and right to sell his shares. In both types of cases, courts impose a greater burden on a vote or sale that will change the status quo of the company. V.C. Laster therefore concluded, “a majority controller can use its voting power permissibly to defend itself and preserve the status quo. But if the majority controller seeks to change the status quo, then the majority controller cannot harm the corporation knowingly or through grossly negligent action.”
Stage Three: What Standard of Review Applies?
Even when one lands on the applicable fiduciary obligations, V.C. Laster observed, Delaware authority is scant on what standard of review applies to determine whether the majority shareholder complied with those obligations. Given the choice between the three tiers of review entrenched in Delaware law—business judgment, enhanced scrutiny, and entire fairness—V.C. Laster held that the enhanced scrutiny standard applies.
Under the enhanced scrutiny standard, Lampert was required to show that his action, in his shareholder capacity, to thwart the Reorganization Plan was taken “in good faith for a legitimate objective.” Lampert was also required to show that he selected a reasonable means for achieving his legitimate objective.
V.C. Laster held that Lampert satisfied his fiduciary duties in connection with his bid to block the Reorganization Plan:
I find by a preponderance of the evidence that the controller did not intend to harm the corporation and its stockholders. He believed in good faith—and I find correctly—that the liquidation plan could not achieve the committee’s lofty expectations . . . Nor did the controller act in a grossly negligent manner . . . Although he did not prepare detailed analyses, he . . . had sufficient information—including about the perils of retail store liquidations—to make an assessment that was not grossly negligent. . . When the controller exercised his stockholder-level voting power, he acted consistently with his fiduciary duties.
If that were the end of the story, the Court observed, judgment would enter in favor of Lampert. But the Court was also called to review, subject to the entire fairness standard, the end-stage transaction that eliminated the interests of the minority shareholders. V.C. Laster found that the end-stage transaction failed that entire fairness review.
What Does Sears Hometown Mean for Closely Held New York Corporations?
The public corporation in Sears and New York closely held corporations start at the same place: the basic principle that a majority shareholder owes fiduciary duties to the minority (Richbell Info. Services, Inc. v Jupiter Partners, L.P., 309 AD2d 288, 300 [1st Dept 2003]). And New York Courts routinely look to Delaware law to inform them on issues of corporate governance (see In re 1545 Ocean Ave., LLC, 72 AD3d 121, 130 [2d Dept 2010]).
With those principles in mind, consider how the roadmap set forth in Sears might migrate to New York Courts considering fiduciary duties in the context of closely held corporations.
On the one hand, closely held corporations are far more likely to see the majority shareholder play several roles, including being an officer and/or director. So the need to distinguish between shareholder-level fiduciary duties and director-level fiduciary duties might not be as pressing in the closely held business context.
On the other hand, V.C. Laster’s decision convincingly argues that perhaps holding the majority shareholders to the same rigorous fiduciary duties as directors, for actions taken solely in their shareholder capacity, misses the mark. In order to enjoy the basic rights associated with share ownership, majority shareholders must have considerably more freedom than a director, finds the Sears Court. For instance, majority shareholders can refuse to sell their shares for any reason, even if a sale would benefit the corporation. And they can vote their shares in their economic interest subject only to minimal restrictions. From these rights, V.C. Laster convincingly opines, a different, less-restrictive level of fiduciary obligation must emerge.
Next time a majority shareholder takes action in her shareholder capacity that the minority shareholders challenge in court, don’t be surprised to see the majority cite Sears Hometown.