United States: Delaware Supreme Court Confirms That Dilution Claims Typically Are Derivative And Are Extinguished After A Merger

Stockholder claims alleging wrongful dilution are typically considered to be derivative in nature.  Several decisions out of Delaware, however, have created exceptions to this general rule allowing stockholders to sue directly (rather than derivatively on behalf of the corporation) where, for example, a controlling stockholder authorizes a "disloyal expropriation" which reduces the economic value and voting power of the non-conflicted stockholders.  See, e.g., Gentile v. Rossette, 906 A.2d 91, 100 (Del. 2006); Gatz v. Ponsoldt, 925 A.2d 1265 (Del. 2007); Feldman v. Cutaia, 951 A.2d. 727 (Del. 2008).  In El Paso Pipeline GP Company, L.L.C. v. Brinckerhoff, No. 103, 2016, 2016 Del. LEXIS 653 (Del. Dec. 20, 2016), the Delaware Supreme Court declined to add to these exceptions and reaffirmed the general rule that dilution claims must be brought derivatively.  As a result, a derivative plaintiff losses his or her standing to pursue a dilution claim if the entity is acquired through a merger.

In Brinckerhoff, El Paso Pipeline Partners, L.P. (the "Partnership") was a publicly traded Delaware master limited partnership.  The Partnership's sole general partner was El Paso Pipelines GP Company, L.L.C. (the "GP"), a subsidiary of El Paso Corporation (the "Parent").  The GP owned all of the Partnership's general partner interest, which represented a 2% economic interest in the Partnership.

In 2010, the GP approved two self-dealing transactions whereby the Partnership purchased property from the Parent.  The first transaction involved the sale of a 51% interest in Southern LNG Company, L.L.C. ("Southern LNG") and El Paso Elba Express Company, L.L.C. ("Elba Express").  The second transaction involved the Partnership's purchase of the remaining 49% interest in Southern LNG and Elba Express, plus the purchase of a 15% interest in Southern Natural Gas Company.  Both transactions were approved by a conflicts committee of the Partnership's board of directors, after it had obtained advice from its financial and legal advisors.  Subsequently, Kinder Morgan, Inc. ("Kinder Morgan") acquired the Parent, after which the Parent ceased to be a publicly traded corporation.

In December 2011, plaintiff filed a verified derivative complaint, naming as defendants the GP, Parent and the members of the special committee of the board of directors that approved the transactions.  Plaintiff accused defendants of breach of express and implied duties, aiding and abetting, tortious interference and unjust enrichment.  In June 2014, after considering the parties' cross-motions for summary judgment, the Delaware Court of Chancery granted defendants' motion as to all claims except for plaintiff's claim for breach of the self-dealing clause in the partnership agreement in connection with the second purchase from the Parent.

In July 2014, Kinder Morgan met with members of the GP's board of directors and offered to acquire the Partnership.  In August of 2014, Kinder Morgan and the Partnership announced the merger, but plaintiff chose not to challenge the merger.  Instead, at trial in November 2014, plaintiff focused on proving damages by showing that the Partnership had overpaid for the assets it purchased through the second transaction.

Shortly after trial, on November 26, 2014, the majority of the Partnership's outstanding common units approved the merger with Kinder Morgan.  In response, defendants filed a motion to dismiss the plaintiff's claims as moot, but the Chancery Court never ruled on that motion.  Instead, on April 20, 2015, the Chancery Court issued a detailed opinion holding the GP liable for breaching the partnership agreement in connection with its approval of the second transaction.  The Court found that the Partnership suffered $171 million in damages.  It held that because the claim for breach of the partnership agreement was not exclusively derivative, plaintiff could enforce the liability award irrespective of the merger.  Specifically, the Chancery Court relied upon the limited exception in Gentile to find direct standing because the GP reallocated value from the unaffiliated limited partners to the GP, which injured all of the investors in the partnership proportionately.  See also In re El Palso Pipeline Partners, L.P. Deriv. Litig., C.A. No. 7141-VCL (Del. Ch. Dec. 2, 2015) (fashioning remedy predicated upon derivative nature of the claim).

On appeal, the Delaware Supreme Court reversed, holding that plaintiff's claims were exclusively direct because they were for economic dilution.  That plaintiff alleged breach of the partnership agreement did not change the fact that the claims were derivative in nature.  The partnership agreement allowed the partnership (and not the limited partners, individually) to recover where there was a breach of the self-dealing provision in that agreement.

In Tooley v. Donaldson, Lufkin & Jenrette, Inc., 845 A.2d 1031 (Del. 2004), the Delaware Supreme Court determined that the derivative or direct nature of a claim "must turn solely on the following questions:  (1) who suffered the alleged harm (the corporation or the suing stockholders, individually); and (2) who would receive the benefit of any recovery or other remedy (the corporation or the stockholders, individually)."  Applying this test, it was clear that plaintiff's claims were solely derivative.  The plaintiff's core theory was that the Partnership was injured when defendants caused the Partnership to overpay for the second transaction.  Claims of corporate overpayment are treated as causing harm solely to the entity and, thus, are solely derivative.  Similarly, the remedy belonged to the Partnership.  Any economic harm to the plaintiff devolved upon him as an equity holder in the form of a proportionally reduced value of his units — a classic derivative injury.  In sum, plaintiff's contract claim was in no way separate or distinct from the claim and rights of the Partnership.

The Delaware Supreme Court rejected any argument that plaintiff could salvage his claim under Gentile.  It "declined to extend Gentile further to say that a direct claim arises wherever a controlling stockholder extracts economic value from an entity to its benefit and to the detriment of the minority stockholders."  Such an expansion of Gentile, the Court held, would swallow the general rule that dilution claims are classically derivative.

Because plaintiff's claims were solely derivative, those claims transferred to Kinder Morgan upon the closing of the merger.  As a result, plaintiff lost his standing to pursue the derivative claims.  Plaintiff's only remedy would have been to challenge the merger.  But, plaintiff did not challenge the merger and could no longer pursue any claim in connection with the second transaction.

Brinckerhoff reins in the exception created by Gentile.  A stockholder dilution claim is the quintessential derivative claim.  As most dilution claims will involve some dilution of both the economic value and voting power of the non-conflicted stockholders, the test for whether a claim is direct should depend on whether a transaction shifts control of a company form a diversified investor base to a single controlling stockholder.  Mere economic dilution will not convert a classically derivative claim into a direct or "dual nature" claim.

The content of this article is intended to provide a general guide to the subject matter. Specialist advice should be sought about your specific circumstances.

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