ATTORNEY: Gustavo F. Bruckner
POMERANTZ MONITOR, JANUARY/FEBRUARY 2015
When a controlling shareholder, who also happens to be the CEO of the company, proposes to take the company private, the situation is ripe for abuse. That’s exactly what we believe occurred in the case of Zhongpin Inc., a Delaware company headquartered in China.
In 2013 Xianfu Zhu, Zhongpin’s CEO, who owned 17.3% of the company’s shares, offered to acquire all shares of the company that he did not own for $13.50 per share. Even though there was another, higher offer for the company on the table, Zhu refused to raise his price, stating that he would not remain as CEO if an alternate bidder acquired a majority stake, would not engage in discussions with third-party investors interested in acquiring the company and would withdraw his proposal if the special committee of the Board formed to consider his offer did not approve it within several days.
The special committee retained Barclay’s Bank to act as financial advisor on the transaction, but it later resigned without ever rendering a fairness opinion. Nonetheless, the special committee approved the deal, and a tiny majority of unaffiliated shareholders ratified it.
Pomerantz is co-lead counsel representing shareholders in a class action in Delaware that seeks damages for investors injured by this self-dealing transaction. Defendants moved to dismiss our action, arguing that Zhu was not a controlling shareholder of Zhongpin because he owned only 17.3% of its shares, and that he therefore did not owe fiduciary duties to other shareholders.
Late last year, in a victory for shareholders, Pomerantz successfully argued that even a 17.3% shareholding stake could be sufficient to assert control, and that the transaction therefore had to be evaluated under the “entire fairness” standard. The Chancery Court rejected the motion to dismiss and the case will proceed to trial.
Because they manage the business for the benefit of the shareholders, corporate directors and officers occupy a fiduciary relationship to both the corporation and its shareholders; but shareholders do not normally owe fiduciary duties to other shareholders. However, when a shareholder “controls” the company, courts have found that he or she owes similar duties as directors to the other shareholders. That is because a controlling shareholder can dominate and control the conduct of the Board and will be held to have indirectly acted in a managerial capacity and thus to have assumed the burden of fiduciary responsibility.
The issue of whether Zhu had control was therefore at the heart of defendants’ motion to dismiss. Under Delaware law, clearly a shareholder owning a majority of a corporation’s stock would be considered a controlling shareholder since with one share more than 50%, such a shareholder could place its own designees on the Board and assure every corporate decision is decided in its favor. Courts have found that some large holders, albeit less than majority holders, may still be considered controlling shareholders if they exert actual control over the Board. That is, they have the power to elect their slate of directors, to adopt or reject fundamental transactions proposed by directors or exercise control over the corporation’s business affairs.
The fact that Zhu was CEO and owned a 17.3% stake was not enough to give him control over the board. In fact, Delaware courts had previously dismissed similar claims of control in other cases where the allegedly controlling shareholder held such a small stake.
In our case, the court held that “Plaintiffs do not need to prove that Zhu was a controlling stockholder in order to withstand the motions to dismiss. Rather, Plaintiffs must plead facts raising the inference that Zhu could control Zhongpin.” The court also held that “while most owners of 17% of a corporation’s stock are not controllers, a plaintiff may argue that given the circumstances of a particular case, such a sizeable stockholder actually exercises control.”
Here the court held that the circumstances supported just such an inference. During the sales process, the company filed its annual report which stated that Zhu “has significant influence over our management and affairs and could exercise his influence against” the best interests of shareholders. The annual report referred to him as the “controlling shareholder” and also stated that as a result of his alliances, and pursuant to the company’s By-Laws, he could “exercise significant influence” over the company, including election of directors, selection of senior management, amount of dividend payments, the annual budget, changes in share capital and preventing a change of control. The court concluded that “Zhu exercised significantly more power than would be expected of a CEO and 17% stockholder” and that “one can reasonably conceive that Zhu could ‘control the corporation, if he so wishe[d].” Under the circumstances, the court held, Zhu’s dominance “left the company with no practical alternatives other than to accept his proposal.”
This has implications for challenges to buy-out proposals submitted by controlling shareholders. Courts seek to protect minority shareholders from the whims and self-interest of controlling shareholders just as they do from the self-interest of corporate directors.
Typically when a shareholder, unhappy over the sale of the company, brings an action against the company’s board of directors to challenge the transaction, a court will defer to the business judgment of the company’s board of directors. The “business judgment rule,” as this protection is known, affords corporate officers and directors who are not subject to self-dealing conflicts of interest immunity from liability to the corporation for losses incurred in corporate transactions within their authority, so long as the transactions are made in good faith and with reasonable skill and prudence. In such a situation, the shareholder-plaintiff has the high burden of proving that the directors’ actions were not made in good faith in order to successfully challenge the transaction.
However, if the directors should have self-interests in the transaction, the burden shifts to the director-defendants to prove the “entire-fairness” of the transaction. The court will also impose the heightened scrutiny of the entire fairness standard of judicial review over the transaction.
Similarly, when a controlling shareholder engages in a self-dealing transaction with its controlled corporation, entire fairness review will apply. That is the standard the court applied here.