United States: Nevada Supreme Court Adopts Delaware's Tooley Test To Determine Whether Shareholder Claims Are Direct Or Derivative

In Parametric Sound Corp. v. The Eighth Judicial District Court of the State of Nevada, ___ P.3d ___, 2017 WL 4078845 (Nev. Sept. 14, 2017), the Nevada Supreme Court addressed the circumstances under which breach of fiduciary duty claims asserted in connection with a strategic transaction may be brought by shareholders directly (including in a class action) or must be bought derivatively, on behalf of the corporation. In reaching its decision, the Supreme Court expressly adopted the test articulated by the Delaware Supreme Court in Tooley v. Donaldson, Lufkin & Jenrette, Inc., 845 A.2d 1031 (Del. 2004), and clarified prior ambiguities in Cohen v. Mirage Resorts, Inc., 119 Nev. 1, 62 P.3d 720 (2003). The Nevada Supreme Court thus held that whether a claim is direct or derivative turns on the following two 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, the Court granted defendants' petition for writ of mandate and directed the district court to dismiss the shareholder plaintiff's direct, class claims for breach of fiduciary duty arising from the approval by the board of directors of Parametric Sound Corporation ("Parametric") of a reverse triangular merger between a subsidiary of Parametric and VTB Holdings, Inc. ("Turtle Beach"). This decision provides much needed legal certainty in a jurisdiction seeking to expand its incorporations.

Parametric is a publicly traded corporation. In 2014, Parametric and Turtle Beach agreed to a reverse triangular merger. In a typical reverse triangular merger, the acquiring corporation forms a subsidiary, which is then merged into the target corporation. The target corporation assumes all of the assets, rights, and liabilities of both the target corporation and the subsidiary. The subsidiary ceases to exist and the target corporation survives the merger and becomes the acquiring corporation's subsidiary.

Here, to accomplish the merger, Parametric created a subsidiary named Paris Acquisition Corporation ("Paris") and Paris was merged into Turtle Beach. Paris ceased to exist and Turtle Beach became a subsidiary of Parametric. Over 90% of Parametric shareholders voted to authorize the issuance of new stock to the Turtle Beach shareholders as consideration for the transaction. Prior to the transaction, Parametric had annual gross profits of about $271,000, whereas Turtle Beach had annual gross profits of about $63.7 million. After the transaction (which closed in early 2014), the original shareholders of Parametric (who continued to hold the same number of shares) held 20% of Parametric, while the former shareholders of Turtle Beach owned approximately 80% of Parametric. Parametric was then renamed Turtle Beach Corporation, a new board of directors was elected and a new management team was installed.

Several shareholders filed actions challenging the merger and the cases were ultimately consolidated in the Nevada district court. The operative complaint asserted two causes of action: (i) breach of fiduciary duty against Parametric's board of directors; and (ii) aiding and abetting breach of fiduciary duty against Parametric and Turtle Beach. Plaintiffs alleged that: (i) the Parametric directors were conflicted when they approved the merger; (ii) the directors approved deal protection agreements that were coercive and preclusive — depriving the shareholders of a meaningful vote while warding off potentially superior merger offers; (iii) the directors intentionally delayed announcing positive information about Parametric in an attempt to manipulate the merger premium; and (iv) as a result of the wrongful conduct, Parametric's valuation was lower that it should have been resulting in a 65% to 82% dilution of the pre-merger value of pre-merger shareholders' Parametric stock.

Defendants moved to dismiss the complaint, arguing that the shareholders lacked standing because their claims were derivative, not direct. The district court denied the motion, which prompted defendants to file a writ petition to the Nevada Supreme Court. The Nevada Supreme Court granted writ review and stayed the district court's proceedings pending its decision.

Defendants argued that Cohen required the loss of unique personal property for a direct claim to exist in connection with a merger transaction. Because the Parametric shareholders continued to own the same number of Parametric shares before and after the merger, the shareholders could not state a direct claim. Defendants also contended that the merger discussions in Cohen did not apply because Parametric was not a "merging" entity in the reverse triangular merger at-issue. Plaintiffs, in contrast, argued that Cohen only required a complaint to allege wrongful conduct with respect to the validity of a "merger" for the claim to be direct.

The Nevada Supreme Court agreed with defendants. Cohen was focused on discussing cashed-out minority shareholders' rights after a merger. Those claims were direct because the shareholder "ha[d] lost unique personal property — his or her interest in specific corporation" and the shareholder was the party entitled to the recovery. The holding in Cohen, however, was ambiguous because it did not adopt an express test for distinguishing direct and derivative claims.

In Parametric, the Nevada Supreme Court adopted the test in Tooley. Applying Tooley to case at-hand, the Court held that the shareholders' claims were solely derivative. First, the use of the term "merger" is not dispositive — the real issue is whether there is a direct harm to the shareholder (and a concomitant right to a direct recovery). Second, there was no merger of Parametric because, in a reverse triangular merger, the merger was between Paris (a Parametric subsidiary) and Turtle Beach. Third, the shareholders lost no personal property, they merely sought damages for equity dilution to Parametric — a claim which is classically understood as a derivative.

The Nevada Supreme Court further reflected that it may be possible for the shareholders to proceed in a direct action via what is known in Delaware as an "equity expropriation claim" under Gentile v. Rossette, 906 A.2d 91, 99 (Del. 2006). Equity expropriation claims involve a controlling stockholder's or director's expropriation of value from the company, causing the other stockholders' equity to be diluted. Plaintiffs in Parametric did not plead any facts to suggest equity expropriation. Accordingly, the Court directed the district court to dismiss the action, but to grant leave to amend to allow the shareholders to plead an equity expropriation claim, if any such claims exist. The Court went on to note that, in the absence of actual fraud, directors have absolute discretion with respect to the consideration received in exchange for a dilutive stock issuance. See NRS 78.200(2); NRS 78.211(1).

Nevada's adoption of the Tooley test provides a clear standard for determining whether shareholder claims arising from a strategic transaction involving a Nevada corporation may be brought directly or must be brought derivatively. This decision adds welcome certainty with respect to Nevada corporate law.

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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