In 2019 the minority stockholders of TerraForm Power Inc. (the Company) filed a derivative class action in the Delaware Court of Chancery against the Company’s directors and its controlling stockholder, Brookfield Asset Management, Inc. (Brookfield). The stockholders attempted to challenge the issuance of the Company stock to Brookfield for an alleged unfair price, which in turn diluted both the financial and voting interests of the minority stockholders.
While the lawsuit was pending, the Company completed a merger with Brookfield, extinguishing the derivative claims. Brookfield sought to dismiss the action on the grounds that (i) the stockholders’ dilution claims were exclusively derivative because any harm flowed to the corporation, and (ii) the stockholders no longer had standing to bring derivative claims following the merger. Brookfield argued that the concept of “dual-standing” (i.e., direct and derivative standing) established by Gentile should be rejected because it is inconsistent with Delaware precedent. However, the Court of Chancery declined to dismiss those claims, pointing to Gentile’s finding that direct claims can survive post-merger, while at the same time acknowledging that the then-current doctrinal framework was unsatisfying.
The Delaware Supreme Court accepted an interlocutory appeal as an apparent opportunity to clarify the framework for analyzing dilution claims.
The Delaware Supreme Court began its analysis by acknowledging the determination of whether a claim is direct or derivative can be difficult; but the court also observed the importance of a consistent and predictable framework for that determination. The importance of this consistency, the court reasoned, is especially acute because determining whether a claim is derivative or direct is often “outcome-determinative” when a merger removes a stockholder’s standing to pursue derivative claims.
The court then observed that the Gentile carve-out, which allows both direct and derivative claims to be brought in dilution cases involving a controlling stockholder, conflicted with Tooley’s straightforward two-part test for determining whether a claim was derivative or direct. The court further noted that, although Gentile acknowledged that the corporation was injured in cases of dilution, that opinion incorrectly held that dilution by controlling shareholders created a separate, and direct, claim arising out of that same transaction. The court concluded that there is “no principled reason to allow dilution/overpayment claims to proceed directly against controllers when the law rightly refuses to permit such claims to proceed directly in non-controller dilution cases.”
Second, the court noted that the Gentile exception was superfluous under the Tooley analysis, because other legal theories provided stockholders a basis for direct claims to address fiduciary-duty violations in the change of control context. Moreover, Gentile created the potential practical problem of allowing two separate claimants (the corporation and the individual stockholder) to pursue the exact same recovery.
In applying the Tooley framework, the Delaware Supreme Court observed that the thrust of the minority stockholders’ claim was that the private placement was unfair and that the Company suffered harm as a result. Thus, the dilution that allegedly harmed the minority stockholders flowed indirectly to them from the Company in proportion to their former shares of the Company. Further, the court reasoned, any remedy should flow to them the same way – derivatively via the corporation. Therefore, the stockholders’ dilution claims were derivative and they lacked standing to bring those claims as a result of the Company’s merger with Brookfield.