N.C. Supreme Court Holds that Dilution of Shareholders’ Voting Power is an Injury Giving Standing to Sue, but Leaves Open Whether a Minority Shareholder Exercising Actual Control Owes Fiduciary Duties to other Shareholders.
In December 2018, the Supreme Court of North Carolina decided the appeal of Corwin v. British Am. Tobacco PLC in 4-3 decision by Chief Justice Martin, joined by Justices Newby, Ervin, and Jackson. See 2018 WL 6437701, 821 S.E.2d 729, 730 (N.C. Dec. 7, 2018), reh’g denied, 822 S.E.2d 648 (N.C. 2019).
The matter arose from a shareholder dispute concerning Reynolds American, Inc.’s agreement to purchase Lorillard, Inc.
Defendant British American Tobacco, PLC (BAT) owned 42% of the stock of Reynolds and agreed to fund part of the Lorillard transaction by purchasing enough of the newly acquired shares to maintain that 42% ownership interest. The terms of this agreement diluted the voting power of Reynolds’ other minority shareholders, including plaintiff [who] filed a putative class action suit on behalf of similarly situated stockholders asserting a claim for breach of fiduciary duty against, among others, BAT.
Corwin, at *1.
The Business Court had dismissed the case on Defendants’ Rule 12 motions. The Court of Appeals reversed. After taking the case on discretionary review, the Supreme Court reversed the Court of Appeals.
The case presented issues of first impression in North Carolina: (1) whether the dilution of shareholders’ voting power is a distinct injury to allow a direct claim by minority shareholders against another minority shareholder; (2) whether a minority shareholder who exercises actual control of the corporation owes a fiduciary duty to other minority shareholders; and (3) whether the plaintiff adequately allege control by a minority shareholder in this case.
The Supreme Court responded: (1) Yes; (2) definitely Maybe; and (3) No.
Shareholder had Standing to Bring a Direct Claim Against BAT
The Defendants argued that the action was derivative and, therefore, required a pre-suit demand on the corporation. Since Plaintiff had not made a demand prior to suing, Defendants contended that dismissal was mandated.
The Court cited the general rule that shareholders “may not bring individual actions to recover … their share of the damages suffered by a corporation.” 2018 WL 6437701, at *4 (citing Green v. Freeman, 367 N.C. 136, 142 (2013)). But, it noted the two familiar exceptions: when the wrongdoer owes the shareholder a special duty, and when the shareholder suffers a personal injury that is “distinct” from the corporation. Id.
The Court looked to the Delaware for guidance on what makes an injury “distinct.” The Delaware Court of Chancery has recognized that a shareholder’s claim for voting power dilution is distinct from the corporation “where a significant stockholder’s interest is increased at the sole expense of the minority.” Id. at *5 (citing In re J.P. Morgan Chase & Co. S’holder Litig., 906 A.2d 808, 818 (Del. Ch. 2005). That test was apt because, here, the Plaintiffs belonged to a group of Reynolds’ shareholders whose percentage ownership interest would necessarily decrease as a result of the transaction. Applying this Delaware standard, the Court decided that voting power dilution is a distinct injury suffered by shareholders, not the corporation.
The Plaintiffs’ alleged injury was sufficient to confer standing to bring a direct claim against BAT.
Plaintiff did Not Allege a Breach of Fiduciary Duty
Next, the Court considered whether a minority shareholder with actual control could owe a fiduciary duty to another shareholder who lacks control.
When the Business Court considered this issue earlier in the case, it was reluctant to determine whether a “bright-line rule of majority ownership” should prevail over a more flexible factual inquiry that might reveal dominance “without majority ownership or voting control.” Corwin, 2015 NCBC 74, 2015 WL 46128780 ⁋ 46 (N.C. Super. Ct. Aug. 4, 2015). The latter test was advocated by Defendants and embodied by Delaware law. Id. While the Business Court acknowledged that a bright line rule would establish predictability, it cautioned that it could also lead to abuse. Id. ⁋ 54. Judge Gale believed that a bright line test would be better adopted by the legislature or the appellate courts. Id. He predicted that if North Carolina appellate courts “elect[ed] not to impose the rigid requirement of majority ownership … , they would, at a minimum, impose a strong presumption that a minority shareholder owes no fiduciary duty absent detailed facts evidencing actual control equivalent to majority ownership.” Id. ⁋ 60.
When the Court of Appeals decided the matter, like the Business Court, it declined to impose a bright line test of majority ownership. It held that “that a minority shareholder exercising actual control over a corporation may be deemed a ‘controlling shareholder’ with a concomitant fiduciary duty to the other shareholders.” Corwin, 796 S.E.2d 324, 330 (N.C. Ct. App. 2016), rev’d, 821 S.E. 2d 729 (2018). But, it loosened the Business Court’s predicted standard. The Court of Appeals required that a claim based upon shareholder liability “allege specific facts demonstrating or allowing for the reasonable inference of actual control by that shareholder.” Id. at 332 (emphasis added).
[that] a minority shareholder owns shares eight times greater than any other shareholder, is the sole source of equity financing for a transformative corporate transaction, has a contractual right to prohibit the issuance of shares and the sale of intellectual property necessary for the transaction, and … pledges support for the transaction contingent on terms more favorable to it than to other shareholders.
Id. at 326. According to the Court of Appeals, these facts showed more than influence—they reasonably implied control.
How would the Supreme Court address this divide between the courts below? Again, it looked to Delaware.
Delaware law imposes fiduciary duties on minority shareholders who exercise actual control. But, the requirement to show actual control is a tougher row to hoe than the requirement fashioned below by the Court of Appeals. In Delaware, actual control exists “only when the allegedly controlling stockholder exercises such formidable voting and managerial power that [it], as a practical matter, [is] no differently situated than if [it] had majority voting control.” Corwin, 2018 WL 6437701, at *7 (citing In re KKR Fin. Holdings LLC S’holder Litig., 101 A.3d 980, 993 (Del. Ch. 2014) (alterations in original)). The stockholder’s “power must be so potent that independent directors … cannot freely exercise their judgment, fearing retribution.” Id. (citing In re KKR, 101 A.3d at 993).
Citing Delaware law, the Supreme Court decided that there must be “well-pleaded facts” of control preventing directors from “freely exercising their judgment in determining whether or not to approve and recommend” a transaction.” Id. (quoting In re KKR, 101 A.3d at 993). It determined that, here, even if it applied the “Delaware controlling-stockholder standard,” and imposed fiduciary duties on a minority stockholder who exercises actual control over a board of directors, the complaint did not adequately allege that BAT exercised such actual control. Corwin, 2018 WL 6437701, at *7. In fact, it disclosed facts that necessarily defeated the claim. Id. at *13 (citing Wood v. Guilford C’nty, 355 N.C. 161, 166 (2002)).
Under the Supreme Court’s reasoning, BAT’s contractual rights may have given it favorable terms under the sale, but that alone is insufficient. Moreover, BAT had contractual handcuffs that actually prevented it from controlling the board. Id. at *8. This existence of contractual restrictions on the exercise of control may prevent a finding of the type of control sufficient to impose a fiduciary duty. Id.
The Supreme Court did not declare a new rule imposing fiduciary duties on a minority shareholder exercising actual control. It merely held that because the Plaintiff failed to allege facts showing actual control, there could be no fiduciary duty. Id.
The dissent believed that the complaint satisfied North Carolina’s liberal notice pleading standard, and would have required the Court to decide the ultimate question of whether North Carolina will follow the Delaware approach.
It is curious that the Court had this issue of first impression before it and chose not to craft North Carolina law. Neither the majority opinion nor the dissent gave much in the way of hints as to how the Court would have come out had it actually decided the issue. However, as the Court followed Delaware law on the issue of standing, it would not be a stretch to predict that it would have similarly followed Delaware law on the issue that it declined to reach.
Another interesting note to this case is found in footnote 7 of the majority opinion and concerns the Rule 12(b)(6) standard in North Carolina. The majority admits a possible “lack of doctrinal consistency in our standard of review for Rule 12(b)(6) motions.” Id. at n.7. The Court declined to address that potential inconsistency, however, because it was not one of the issues brought forward in the petition for discretionary review. That issue was central in Plaintiff’s petition for rehearing, which was denied. See 822 S.E. 2d 648 (N.C. 2019).
The decision of the N.C. Supreme Court affirmed the Business Court’s original decision in this matter. Judge Gale’s prediction regarding the appellate courts’ treatment of fiduciary duties in this context proved prescient. There is now a strong presumption that a minority shareholder owes no fiduciary duty to other shareholders absent detailed factual allegations of control that prohibits the free exercise of directors’ judgment.
For an additional perspective on this case (and two other Business Court appeals), see the December 20, 2018 post on Fox Rothschild’s North Carolina Appellate Practice Blog. Supreme Court Gets Down to Business-Business Court Cases, That Is