At the same time SmileDirectClub, Inc. (SmileDirect or the Company) went public in September 2019, the Company issued a prospectus that indicated it would use IPO proceeds to fund certain insider transactions if enough money was raised. These insider transactions, the plaintiffs claimed, would dilute public shareholders.
The plaintiffs alleged that more than $696 million in funds that were raised through the IPO were used to pay corporate insiders for the Company’s stock. In addition, the Company’s share price dropped shortly after it went public, allegedly due to certain undisclosed regulatory and financial challenges.
The plaintiffs, who purchased stock and became stockholders as part of the IPO, brought derivative claims for breaches of fiduciary duty against the board of directors (the Board), alleging that these regulatory and financial challenges were known before the Board approved the insider share repurchases at an allegedly inflated IPO price.
The Company moved to dismiss this action, claiming the plaintiffs lacked standing under 8 Del. C. section 327 and the court’s decision in 7547 Partners v. Beck, 682 A.2d 160 (Del. 1996).
The court began its analysis by reiterating that typically, when a stockholder seeks to bring a derivative action, that stockholder must have been a stockholder at the time of the challenged transaction and must remain a stockholder through the litigation. The court explained that, while there are certain limited exceptions, this rule is intended to prevent people from purchasing shares of a company for the sole purpose of filing a derivative case.
The plaintiffs claimed that although they were not stockholders of SmileDirect until after the IPO, they should be deemed to have standing because the Company’s prospectus stated what the Board “intends to do,” and that phrase constituted a forward-looking statement in which prices were not definitively known. Therefore, since the Company’s stock price fell after the terms of the insider transaction were made public through the prospectus, the plaintiffs argued that the court should hold that the stockholders did have standing to bring a derivative claim.
The court rejected this argument and held that “[t]he prospectus’s necessary use of ‘intends’ to describe future transactions that are dependent on raising capital does not change the fact that the pricing of those transactions – which is plaintiffs’ principal complaint – was set.” Further, the court noted that “[t]he insider transactions were necessarily structured and disclosed in forward-looking terms, as the company could not have completed them if the IPO flopped, and could not complete them until the company received its proceeds.” Therefore, the court noted that plaintiffs’ “theory would have the curious result of permitting a party to complain in the name of the corporation about the transaction in which that party purchased stock from the corporation,” and is barred under the contemporaneous ownership rule.
The Delaware Court of Chancery’s ruling makes clear that derivative standing is not extended to stockholders of Delaware corporations when those stockholders seek to challenge the same transaction in which they became stockholders in the corporation, so long as those challenged actions are disclosed in regulatory filings.
Client Alert 2021-186