Until recently, Delaware law offered no clear standard of review for a controller's exercise of stockholder voting power. On January 24, 2024, the Delaware Court of Chancery addressed this issue at length in a decision awarding more than $18.3 million to the plaintiffs, minority stockholders in Sears Hometown and Outlet Stores, Inc. (the company). For the first time, the Chancery Court held that a controlling stockholder owes duties of good faith and care to both the corporation and its minority stockholders. The court also determined that enhanced scrutiny, rather than the business judgment rule, was the proper standard for reviewing a controller's actions when facing a "subtle conflict" — here, the controller had business agreements with the corporation that could have skewed his judgment.
At issue in the case, the plaintiffs alleged that the controller exercised his voting power to effectively stall the board's plan to liquidate one of the company's business segments and then to acquire the company himself. First, they alleged that the controller slowed down the liquidation plan by voting to enact a bylaw requiring two separate approvals of the plan. The controller also allegedly voted to remove two directors who backed the liquidation plan, and he replaced them with affiliates of his financial backers. The court found by a preponderance of evidence that the controller did not intend to harm the corporation and its stockholders, nor was he grossly negligent. Instead, because the controller engaged in discussions with the committee, understood the liquidation plan, and had the most to lose as a stockholder if the plan failed, the court found he acted consistently with his fiduciary duties.
After applying entire fairness review, the court found, however, that the controller paid a price that was below the range of fairness, noting that he tilted the playing field in his favor, especially because he removed the directors who were his "most visible and vigorous opponents," which "cast a shadow over the balance of the negotiations." While the court found that the controller sincerely believed that the transaction was fair, it nonetheless held him liable for what it concluded was an unfair transaction.
This case provides guidance for controllers who plan to use their stockholder voting power to effect change or intervene in company affairs. If they do so, Delaware courts may find they owe duties of good faith and care and thus they must avoid harming the corporation or its minority stockholders, intentionally or through gross negligence. Controller intervention might also implicate heightened standards of review. It is yet to be seen whether the Delaware Supreme Court will adopt this standard, but for now, courts and controllers have a reference point when analyzing a controller's use of stockholder voting power.
Mi v. Waterdrop Inc., 2024 WL 159191 (2nd Cir. Jan. 16, 2024)
On January 16, 2024, the Second Circuit affirmed dismissal,with prejudice, of a putative class action brought by investors who purchased American Depositary Shares in the initial public offering of Waterdrop, Inc. (Waterdrop), an online Chinese insurance company.
Waterdrop's business consisted of three segments: a commercial insurance platform (its primary source of revenue), a crowdfunding platform enabling donations to people with high medical bills, and a mutual aid platform enabling people to spread medical costs.
In late 2020, Chinese regulators began scrutinizing online insurance companies and cracking down on mutual aid platforms, such as the one Waterdrop offered. By early 2021, Waterdrop's mutual aid platform ceased operations. Despite this setback, Waterdrop proceeded with a May 2021 IPO.
The plaintiff alleged primarily that the company's registration statement filed in connection with the IPO was misleading because, while it "disclosed the cessation of Waterdrop's mutual aid platform . . . it obscured the true reasoning behind the cessation" (i.e., scrutiny from Chinese regulators) and "downplay[ed] the effects that the hostile regulatory environment in China" had on the company. Additionally, the plaintiff alleged that the registration statement disclosed certain interim financials from Q1 of 2021 while omitting a sharp increase in expenses that occurred during that quarter.
The Second Circuit rejected both allegations, finding that the registration statement "spoke in detail about the regulatory environment and the risks it presented to Waterdrop's business." Specifically, the registration statement explained that Waterdrop operated in a "highly regulated industry in China" and that Chinese regulators had been "enhancing . . . supervision" of the online insurance industry. Therefore, the court concluded that explicitly stating that the mutual aid program was discontinued due to pressure from Chinese regulators would not have significantly altered the total mix of information available to investors.
Next, the court turned to the plaintiff's allegations regarding increases in the company's aggregate expenses in Q1 2021. The court found the registration statement's repeated warnings that "operating costs and expenses had increased and were expected to continue to increase in the foreseeable future" sufficiently disclosed the risks Waterdrop faced and dismissed this allegation as well.
The court noted that the plaintiff's claims relied on reading certain statements out of context, but federal law requires courts to read the registration statement cover to cover and consider whether all the disclosures, taken together, are misleading. Overall, the court found the registration statement described a risky and speculative investment in an upstart growth company that had never been, and might never be, profitable. The court thus affirmed the lower court's grant of dismissal with prejudice.
This opinion is a helpful reminder regarding the import of carefully crafting risk disclosures, tailored to specific risks a company may face. The more specific risk disclosures are to an issue that comes to fruition, the lower the likelihood that a court will determine that statements relating to that issue are actionably false or misleading.
SEC Releases Final Rules Regarding SPAC and De-SPAC Transactions, Enhancing Disclosure Requirements and Extending Liability to Targets
On January 24, 2024, the Securities and Exchange Commission (SEC), by a vote of 3-2, adopted final rulesregulating special purpose acquisition company (SPAC) IPOs and other business combinations involving SPACs.
According to the SEC's published guidance, these changes are intended to enhance investor protections in connection with SPAC transactions and in particular provide (i) enhanced disclosure requirements, including information on compensation paid to sponsors, conflicts of interest, dilution, and the determination of a board of directors governing a SPAC regarding whether a de-SPAC transaction is advisable; and (ii) more expansive liability for SPACs, target companies, and their directors and officers. This latter change includes removing the protections of the Private Securities Litigation Reform Act (PSLRA) for forward-looking statements made by SPACs as well as providing for co-liability for target companies regarding disclosures made in connection with the merger.
The new rules first set forth a number of new disclosure requirements applicable to de-SPAC transactions, including a handful of disclosure requirements that aim to protect investors from a SPAC's overly optimistic financial projections. For example, SPAC entities must "clearly distinguish" in their disclosures which financial projections are not based on historical financial results and which projections are based on historical financial results or operational history. And in de-SPAC transactions, SPAC entities must now also disclose the purpose of the projections, who prepared the projections, the material underlying assumptions of the projections and any factors that could impact these assumptions, and whether the projections still reflect the views of the board or management of the SPAC or target company as of the date of the filing.
The rules also subject SPACs and target companies to further potential liability for forward-looking statements in connection with de-SPAC transactions. The SEC's revised definition of "blank check company" makes the PSLRA's safe harbor unavailable for forward-looking statements made in connection with SPAC transactions, including statements regarding both acquirer and target financial projections. The PSLRA provides a safe harbor for forward-looking statements under the Securities Act and the Exchange Act, under which a company is protected from liability for forward-looking statements in any private right of action, when the statement is identified as such, and is accompanied by meaningful cautionary language. However, under Rules 405 and 12b‑2, the safe harbor is generally not available in traditional IPOs or in offerings by "blank check" companies. The new rules define "blank check" companies specifically to include SPACs. Without the PSLRA's protection, routine forward-looking statements, even when accompanied by meaningful cautionary language, could expose SPAC entities to potential liability if those statements are materially misleading or omit material information. This is particularly noteworthy given the inherent uncertainty in predicting a SPAC's future revenues without prior historical results.
Ninth Circuit Affirms Dismissal of Putative Securities Class Action Against Video Game Giant Activision Blizzard
On January 19, 2024, the US Court of Appeals for the Ninth Circuit affirmedthe dismissalof a putative class action brought by shareholders against Activision Blizzard, Inc. (Activision), and certain of its officers and directors. The shareholders brought claims under Sections 10(b) and 20(a) of the Exchange Act for allegedly downplaying the importance and potential effect of investigations commenced by the US Equal Employment Opportunity Commission (EEOC) and California Department of Fair Employment and Housing (DFEH) into claims of sexual harassment and gender-based discrimination. Among other things, the shareholders pointed to statements in SEC filings that the company was subject to "routine . . . investigations . . . arising from the ordinary course of business" and that Activision "[did] not expect them to have a material adverse effect." According to shareholders, the alleged truth was revealed when Activision disclosed a significant risk that one of the agencies might find "cause" for one or more of its claims.
The Ninth Circuit ruled that the shareholder plaintiffs failed to meet the heightened pleading requirements of the PSLRA because they did not plead facts leading to a strong inference of scienter, i.e., that an executive knew or deliberately disregarded that the DFEH and EEOC investigations were nonroutine, significant, and likely to have material adverse outcomes. According to the Ninth Circuit, because Activision could have scienter only through that executive, the plaintiffs also failed to plead scienter as to the company.
In affirming the district court's decision, the Ninth Circuit appeared to endorse the lower court's findings that the plaintiffs failed to plead scienter by alleging, among other things, that executives were generally aware of the pervasive sexual harassment at the company, knew details of investigations, were involved in the firing of senior employees in connection with the claims of harassment, and that the media's outsized reaction to the investigations belied any notion that the investigations were routine. In short, the district court rejected such allegations as conclusory, or as fraud by hindsight, i.e., allegations that the defendants "should have known" that the statements in the SEC filings were false, which are insufficient to plead scienter. The district court also rejected the plaintiff's allegations that another executive was aware of the alleged culture problems, holding that his scienter could not be attributed to the company because he was not alleged to have made any statements.
This case reinforces the high pleading bar of the PSLRA and cautions against allegations of general, "collective" scienter in place of individualized allegations about the actual speaker of the false statement.
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