In Calesa Associates, L.P. v. American Capital, Ltd., Vice Chancellor Glasscock denied defendants’ motion to dismiss plaintiffs’ claims alleging that directors of Halt Medical, Inc. (“Halt”) and its alleged controller American Capital, Ltd. (“American Capital”) had engaged in an unfair financing transaction. In doing so, Vice Chancellor Glasscock acknowledged an interesting nuance of the pleading stage in Delaware corporate law. Suits alleging that a director’s breach of loyalty resulted in a dilution of stockholder value in favor of an insider may be brought either derivatively or directly. This option affords shareholders pursuing such a claim a choice between two different pleading standards: the particularized pleading standard required for derivative suits by Court of Chancery Rule 23.1 or the more lenient Court of Chancery Rule 12(b)(6) standard for direct suits. It is not difficult to predict which pleading standard plaintiffs would choose.
The plaintiffs’ claim in Calesa fits within the interesting set of shareholder grievances that share features of both a derivative claim and a direct claim. In their complaint, plaintiffs allege that Halt’s directors and American Capital, a 26% shareholder of Halt, orchestrated an unfair and deceptive financing transaction between American Capital and Halt. As part of the transaction, American Capital would loan Halt up to $73 million, gain four board seats, and receive new shares of preferred and common stock, increasing American Capital’s equity position from 26% to 66%, thus diluting the other stockholders’ positions. The transaction also called for a new compensation plan, in which the compensation of Halt’s CEO, who was also a director, doubled.
Plaintiffs brought suit seeking to enjoin the transaction, alleging that five of Halt’s directors were under the control of American Capital and that the transaction unfairly diluted the plaintiffs’ shares and extracted value from the company. For this type of claim, Vice Chancellor Glasscock recognized that plaintiffs could pursue two distinct approaches to litigation. Under one approach, plaintiffs could pursue their claims derivatively because the alleged extraction of value and overcompensation of interested directors harms the corporation. Under the other approach, plaintiffs could pursue the claims directly because their equity positions were diluted by the transaction. Even though they are based on the same facts, however, the two approaches implicate different pleading requirements.
Shareholders suing derivatively on behalf of the corporation must comport with Court of Chancery Rule 23.1 and Aronson to survive a motion to dismiss. Specifically, plaintiffs must allege particularized facts to support an inference that the directors were not disinterested and independent or that the transaction was not the product of a valid exercise of business judgment. Shareholders suing directly must satisfy a much lower pleading standard. To survive a motion to dismiss under Rule 12(b)(6), the shareholders’ complaint must raise a “reasonable conceivability” of recovery. Given that shareholders have a choice of pleading standards, it is not difficult to predict which path they would choose.
In Calesa, neither party argued that the heightened pleading standard of Rule 23.1 was appropriate, and, in fact, defendants moved to dismiss the complaint under Rule 12(b)(6). Accordingly, Vice Chancellor Glasscock analyzed the complaint under the “reasonable conceivability” standard—i.e., whether based on the allegations in the complaint it is reasonably conceivable that plaintiffs are entitled to relief. Whether the allegations would entitle plaintiff to relief depends on the level of scrutiny with which the Court reviews the allegations. The business judgment rule presumes that directors have acted in good faith and in the best interests of the company. However, plaintiffs can overcome that presumption by adequately alleging facts to support a reasonable inference that “(1) a controlling stockholder stands on both sides of a transaction or (2) at least half of the directors who approved the transaction were not disinterested or independent.” If plaintiffs allege facts supporting such inferences, then the Court of Chancery will examine whether the transaction was entirely fair. Here, Vice Chancellor Glasscock found that plaintiffs had alleged facts to show that American Capital, despite owning only 26% of the outstanding shares, was a controlling stockholder in Halt and that a majority of Halt’s directors were controlled by American Capital.
Although in this particular case defendants moved to dismiss the complaint under 12(b)(6), Vice Chancellor Glasscock recognized that it could have been “self-evidently reasonable and efficient” to require the particularized pleading standards of Rule 23.1. The existence of these two different pleading standards for the same claim raises this question: does the heightened pleading standard of Rule 23.1 have continuing utility?
The answer seems two-fold. First, Rule 23.1 will undoubtedly continue to apply outside of cases, like Calesa, in which the shareholders’ allegations implicate that narrow space of Delaware law that has accommodated two pleading standards for the same set of facts. That the particular set of facts at issue in Calesa allowed plaintiffs to avoid Rule 23.1 in favor of a less onerous pleading standard does not suggest the total impracticality of Rule 23.1. As Vice Chancellor Glasscock noted in his opinion, Rule 23.1 still guards against strike suits involving actions or transactions not involving dilution of existing shares. Second, the Court of Chancery’s opinion in In re El Paso Pipeline Partners, L.P. Derivative Litigation discusses the consideration of “how a dual-natured claim should be treated for purposes of Rule 23.1” and how “Delaware law can and should prioritize the derivative aspects of the claim.” Even though the defendants in Calesa failed to argue that plaintiffs’ claims were subject to Rule 23.1 and, instead, moved to dismiss under Rule 12(b)(6), the Court of Chancery on two occasions now has opined that, for claims which are both derivative and direct, it is perhaps “self-evidently reasonable and efficient” to require the particularized pleading standards of Rule 23.1. The Court of Chancery, in future cases dealing with dual-natured claims, may more formally adopt its own dictum and apply the heightened pleading standards of Rule 23.1 for situations in which plaintiffs have alleged that a director’s breach of the fiduciary duty of loyalty resulted in a dilution of stockholder value in favor of an insider. In such situations, director-defendants should not merely argue that plaintiffs’ claims are derivative. They must also argue that to the extent the claims are direct, they are nonetheless also subject to Rule 23.1.
Matthew Goeller is a 3L student at Delaware Law School and an Articles Editor with the Delaware Journal of Corporate Law.
Suggested Citation: Matthew Goeller, Calesa Associates: Recognizing an Anomaly of Corporate Law Pleadings, Del. J. Corp. L (June 3, 2016), www.djcl.org/blog.