Facebook's proposed issuance of nonvoting stock challenged in Delaware Chancery Court

NBC reports:

A Facebook shareholder filed a proposed class action lawsuit on Friday in a bid to stop the company's plan to issue new Class C stock, calling the move an unfair deal to entrench Chief Executive Mark Zuckerberg as controlling shareholder. ...

The lawsuit contends that a Facebook board committee which approved the share deal "did not bargain hard" with Zuckerberg "to obtain anything of meaningful value" in exchange for granting Zuckerberg added control. ...

Facebook plans to create a new class of shares that are publicly listed but do not have voting rights. Facebook will issue two of the so-called "Class C" shares for each outstanding Class A and Class B share held by shareholders. Those new Class C shares will be publicly traded under a new symbol. 

Zuckerberg "wishes to retain this power, while selling off large amounts of his stockholdings, and reaping billions of dollars in proceeds," the lawsuit said. 

"The issuance of the Class C stock will, in effect, have the same effect as a grant to Zuckerberg of billions of dollars in equity, for which he will pay nothing," it said. 

Actually, there have been two complaints filed. One is a class action filed on April 29 by a Facebook shareholder named Eric McGinty represented by local counsel Michael P. Kelly and Benjamin A. Smyth of MCCARTER & ENGLISH and LEVI & KORSINSKY, LLP (DC). The other is a class action was filed today by a Facebook shareholder named Eric Levy (what are the odds of them both being named Eric?) represented by local counsel Blake A. Bennett of COOCH AND TAYLOR, PA, with Lynda J. Grant of THEGRANTLAWFIRM, PLLC (NY) and Laurence D. Paskowitz of THE PASKOWITZ LAW FIRM P.C. (also NY). Both complaints allege the the defendants--Zuckerberg and the Facebook board--breached their "fiduciary duties of loyalty, good faith and candor." They also emphasize that the transaction would have a significant entrenchment effect, allowing Zuckerberg to profit by selling his Class C stock while maintaining his control.

First, why are these class actions rather than derivative suits? The Delaware courts have held that whether a suit is derivative or direct is determined by asking "(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)?" Tooley v. Donaldson, Lufkin & Jenrette, Inc., 845 A.2d 1031, 1033 (Del. 2004). prior cases have indicated that entrenchment claims and claims involving dilution of minority voting rights may be brought directly. See, e.g., Wells Fargo & Co. v. First Interstate Bancorp., No. CIV. A. 14623, 1996 WL 32169 (Del. Ch. Jan. 18, 1996).

What standard of review will Chancery apply on these facts? Surely there is an argument that this is a case for entire fairness review:

Under current law, the entire fairness framework governs any transaction between a controller and the controlled corporation in which the controller receives a non-ratable benefit. This is because “Delaware is more suspicious when the fiduciary who is interested is a controlling stockholder.” Leo E. Strine, Jr., The Delaware Way: How We Do Corporate Law and Some of the New Challenges We (and Europe) Face, 30 Del. J. Corp. L. 673, 678 (2005). A controlling stockholder occupies a uniquely advantageous position for extracting differential benefits from the corporation at the expense of minority stockholders. See id. There is also “an obvious fear that even putatively independent directors may owe or feel a more-than-wholesome allegiance to the interests of the controller, rather than to the corporation and its public stockholders.” Id.

[T]he underlying factors which raise the specter of impropriety can never be completely eradicated and still require careful judicial scrutiny. This policy reflects the reality that in a transaction such as the one considered ..., the controlling shareholder will continue to dominate the company regardless of the outcome of the transaction. The risk is thus created that those who pass upon the propriety of the transaction might perceive that disapproval may result in retaliation by the controlling shareholder.

 

*12 Tremont II, 694 A.2d at 428 (citations omitted).

 

In re Ezcorp Inc. Consulting Agreement Derivative Litig., No. CV 9962-VCL, 2016 WL 301245, at *11-12 (Del. Ch. Jan. 25, 2016).

 

Facebook seems to have anticipated the risk of the transaction being subjected to entire fairness review, since they had a special committee of the board approve the transaction rather than leaving it to the full board. The proxy statement states:

The Special Committee was established in August 2015 as a committee of our board of directors to (i) review, analyze, evaluate, and negotiate a potential reclassification of our capital or voting structure in order to maintain our founder-controlled structure, (ii) make a recommendation to our board of directors regarding such a reclassification, and (iii) to the extent delegable by our board of directors to the Special Committee under applicable law, approve or disapprove such a reclassification on behalf of the board of directors.

 

Among other things, our board of directors authorized the Special Committee to retain, at our expense, such legal, financial, and other advisors, consultants, and experts as the Special Committee determined to be necessary or appropriate to assist and advise the Special Committee in performing its responsibilities, and to enter into contracts with such advisors, consultants, and experts for their compensation, reimbursement of expenses, and indemnification. The board of directors also resolved that the Special Committee would have the power to authorize and direct the appropriate officers of the company to provide such information and assistance as may be requested by the Special Committee in the exercise of its responsibilities.

 

Our board of directors (with the employee directors abstaining) appointed Susan Desmond-Hellmann , Marc Andreessen, and Erskine B. Bowles as members of the Special Committee. Following the establishment of the Special Committee, the members of the Special Committee appointed Dr. Desmond-Hellmann as Chairperson of the Special Committee. Our board of directors (with the employee directors abstaining) determined that the members of the Special Committee (i) were not members of our management, (ii) were independent of Mr. Zuckerberg, and (iii) were disinterested with respect to a reclassification, except with respect to any interest they may have by virtue of their ownership of shares of our Class A common stock (subject to obtaining their (and any affiliated funds') irrevocable commitment to cause any of their shares of, or securities convertible into or exchangeable for, our Class B common stock to be converted to Class A common stock to the extent that they beneficially owned shares of, or securities convertible or exchangeable into, our Class B common stock as further described in "Background" below).

What's interesting, however, is that Facebook decided not to avail itself of the newly approved mechanisms for insulating conflicted transactions from fairness review:

If a controller agrees up front, before any negotiations begin, that the controller will not proceed with the proposed transaction without both (i) the affirmative recommendation of a sufficiently authorized board committee composed of independent and disinterested directors and (ii) the affirmative vote of a majority of the shares owned by stockholders who are not affiliated with the controller, then the controller has sufficiently disabled itself such that it no longer stands on both sides of the transaction, thereby making the business judgment rule the operative standard of review. M & F Worldwide, 88 A.3d at 644. If a controller agrees to use only one of the protections, or does not agree to both protections up front, then the most that the controller can achieve is a shift in the burden of proof such that the plaintiff challenging the transaction must prove unfairness.

In re Ezcorp Inc. Consulting Agreement Derivative Litig., No. CV 9962-VCL, 2016 WL 301245, at *11 (Del. Ch. Jan. 25, 2016). Here Zuckerberg gave the minority the protection of a special committee (although both complaints allege significant failures by the committee), but not approval by a majority of the minority. So fairness would remain the applicable standard.

 

Indeed, the proxy statement rubs the minority shareholders' impotence in their face:

As a result of his beneficial ownership of more than a majority of each of our total outstanding voting power and the outstanding voting power of the Class B common stock as of the record date, Mr. Zuckerberg has the power to approve the adoption of the New Certificate without the affirmative vote of any other stockholder.

I'm hoping this case goes the distance (unlike the Google case from a couple of years ago), as it would make a great addition to our case book.