Under Delaware law, a shareholder is deemed to have control if the shareholder either owns a majority of the voting stock or exercises control over corporate decision making.[1] If the shareholder owns less than 50 percent of the voting stock, plaintiff must show evidence of actual control of corporate conduct.[2] Consequently, for example, the Delaware supreme court in Kahn v. Lynch Communication Systems, Inc.,[3] held that a 43.3 percent shareholder exercised control, not based on the number of shares it owned, but because the board of directors deferred to the shareholder’s wishes.
In an interesting new case, Voigt v. Metcalf,[4] plaintiffs claimed that private equity firm Clayton, Dubilier & Rice (“CD&R”) controlled NCI Building Systems, Inc. (the “Company”), pointing to such factors as CD&R’s control of 34.8% of the Company’s voting power, the presence of four CD&R insiders on the Company’s twelve-member board of directors (the “Board”), CD&R’s relationships of varying significance with another four directors, and a stockholders agreement that gave CD&R contractual veto rights over a wide range of actions that the Board could otherwise take unilaterally. Plaintiffs who were minority shareholders of the Company claimed CD&R had used its control of the Company to effect a merger between the Company and a CD&R affiliate.
The defendants moved to dismiss, arguing that CD&R did not have control of the Company and, accordingly, owed no fiduciary duties to the minority. The court noted that because CD&R’s 34.8% ownership stake was than a majority, plaintiffs could only prevail if they “allege facts that support a reasonable inference that the defendant in fact ‘exercise[d] control over the business affairs of the corporation.’”
A plaintiff can plead that a defendant had the ability to exercise actual control by alleging facts that support a reasonable inference of either (i) control over the corporation’s business and affairs in general or (ii) control over the corporation specifically for purposes of the challenged transaction.
To plead that the requisite degree of control exists generally, a plaintiff may allege facts supporting a reasonable inference that a defendant or group of defendants exercised sufficient influence “that they, as a practical matter, are no differently situated than if they had majority voting control.” One means of doing so is to plead that the defendant, “as a practical matter, possesses a combination of stock voting power and managerial authority that enables him to control the corporation, if he so wishes.”
To plead that the requisite degree of control existed for purposes of a particular transaction or decision, a plaintiff does not have make such a pervasive showing. Rather, the plaintiff must plead facts supporting a reasonable inference that the defendant in fact exercised actual control “with regard to the particular transaction that is being challenged.”
“The question whether a shareholder is a controlling one is highly contextualized and is difficult to resolve based solely on the complaint.” “[T]here is no magic formula to find control; rather, it is a highly fact specific inquiry.”
Under the Company’s shareholders agreement, CD&R had a right to appoint four out of the Company’s twelve directors. Even though CD&R’s representatives were less than a majority of the board, the power to appoint them was “an indication of control.” In addition, CD&R has various business relationships with four of the nominally independent directors, which were sufficient to infer at this stage of the proceeding that those directors were beholden to CD&R, which gave CD&R effective control over two-thirds of the board.
In discussing CD&R’s stock ownership, the court acknowledged that there is no “linear, sliding scale approach where by a larger share percentage makes it substantially more likely that the court will find the stockholder was a controlling stockholder.” Nevertheless, “a relatively larger block size should make an inference of actual control more likely, even though the interplay with factors makes the correspondence difficult to perceive.” This is so not only because a large blockholder only needs pick up the votes of a small number of shareholders to prevail, but also because a large blockholder is likely to have significant influence on the board,
In addition to various other minor factors, the court noted that the stockholder agreement contained provisions that cut in opposite directions. On the one hand, the agreement ensured board representation for the minority shareholders. On the other hand, the agreement gave CD&R a de facto video over a number of corporate actions that ordinarily would be left to the discretion of the board.
The consent rights encompassed both significant corporate and financing transactions, as well as more basic corporate governance issues like increasing the size of the Board or amending the bylaws. These blocking rights weigh in favor of an inference that CD&R exercised control over the Company generally by giving CD&R power over the Company beyond what the holder of a mathematical majority of the voting power ordinarily could wield.
Contractual rights that do not amount to a significant source of general control can, depending on the circumstances, give rise to an inference of transaction-specific control, because the holder of the contract rights can use them to channel a corporation into a particular outcome by blocking other paths. Although a blocking right standing alone is unlikely to support a reasonable inference of control, in the context of a particular factual scenario, it can be a highly effective form of control. The paradigmatic example involves a cash-burning, asset-light company that does not yet generate sufficient revenue to finance its business plan and has reached the point where it requires external financing. Under those circumstances, a party that has a veto right over the company’s access to financing can “sit on the company’s lifeline, with the ability to turn it on or off.” When cash is like oxygen, the ability to choke off the air supply is a strong indicator of control, particularly if there are factual allegations (and later evidence) that the party holding the veto right used it to force the company into a vulnerable position.
