(November 24, 2021) - Gardner Davis and Richard Guyer of Foley & Lardner LLP discuss the Delaware Supreme Court's decision in Brookfield Asset Management Inc. v. Rosson, which eliminated standing for a stockholder to directly challenge a corporation's issuance of stock to a controller for inadequate consideration.

Overruling established precedent, the Delaware Supreme Court recently eliminated standing for a stockholder to directly challenge the corporation's dilutive issuance of stock to the controller for inadequate consideration. Brookfield Asset Management, Inc. v. Rosson¹ removed a major inconsistency regarding whether a stockholder claim for overpayment and dilution must be brought on a derivative basis.

Eighteen years ago, in Tooley v. Donaldson, Lufkin & Jenrette, Inc.,² the Delaware Supreme Court established a two-part test to distinguish direct claims from derivative claims: (1) who suffered the harm (the corporation or the stockholders, individually); and (2) who should receive the benefit of any recovery (the corporation or the stockholders, individually)?

Under the Tooley standard, stockholder claims for overpayment and dilution are classically derivative: the fiduciaries, acting in a way that breaches their duties to the corporation, have caused the entity to exchange assets at a loss. The essence of the claim is that the corporation overpaid and therefore the corporation was injured. This rationale logically should apply regardless of whether a controlling stockholder causes a corporate overpayment in stock and consequent dilution to the minority stockholders.

Shortly after deciding Tooley, however, the Delaware Supreme Court held in Gentile v. Rossette³ that a stockholder plaintiff pleads two independent harms arising from a transaction where the controlling stockholder causes the corporation to issue shares for less than fair value and thereby increases the controlling stockholder's percentage ownership of the outstanding stock. In Gentile, the Court determined the corporation is harmed by overpaying, but the minority stockholders suffered an independent injury from dilution of their economic value and voting power.

This special sub-category of a corporate overpayment claim was both derivative and direct in character. Unlike the typical overpayment transaction, a dual-natured claim arises in which the stockholder having a majority or effective control causes the corporation to issue "excessive" shares of its stock, in exchange for assets of the controlling stockholder that have a lesser value. The exchange causes an increase in the percentage of the outstanding shares owned by the controlling stockholder and a corresponding decrease in the share percentage owned by the minority stockholders.

In Gentile, the Delaware Supreme Court acknowledged that, although the corporation suffered harm in the form of the diminution of its net worth in situations involving the controller, the minority stockholders also suffered a harm that was unique to them, as well as independent of any injury to the corporation.

The purportedly independent harm to the minority stockholders resulted from a breach of a fiduciary duty owed them by the controlling stockholder; namely, the duty to not cause the corporation to effect a transaction that would benefit the fiduciary at the expense of the minority stockholders. Gentile held that the value represented by the corporate overpayment may be recovered by the minority stockholders directly, and without regard to any claim the corporation may have.

In Brookfield, the Delaware Supreme Court revisited the ruling in Gentile and found that a clear analytical conflict existed between Gentile and Tooley and that, in light of relevant doctrinal, practical and policy considerations, Gentile should be overruled.

Apart from the sometimes esoteric question of direct versus derivative standing, Brookfield provides helpful, real world guidance regarding best practices for independent directors considering a potential conflict of interest transaction with the controlling stockholder.

The case involves TerraForm Power, Inc. — a publicly traded Delaware corporation which operated wind and solar energy assets. (NASDAQ: TERP).

Brookfield Asset Management owned a majority of TerraForm's outstanding common stock. Pursuant to the terms of Brookfield's initial investment, Brookfield had the right to designate four of TerraForm's seven directors and the CEO.

The TerraForm Board appointed a Conflicts Committee, composed of the three non-Brookfield directors, to review and approve material conflict transactions between TerraForm and Brookfield.

In January 2018, Brookfield approached TerraForm regarding an opportunity to acquire Saeta Yield, S. A., a publicly traded Spanish company that owned and operated wind and solar energy assets, for $1.2 billion. In their lawsuit, the minority stockholder plaintiffs alleged TerraForm had the debt capacity and cash to fund most, if not all of the Saeta acquisition. However, the board's decision to finance an acquisition with equity capital rather than debt is clearly protected by the business judgement rule.

The plaintiff stockholders further contended in their lawsuit that, notwithstanding this debt capacity, the Brookfield directors steered TerraForm towards funding the deal with an equity offering that allegedly allowed Brookfield to increase its ownership percentage of TerraForm at a discount to TerraForm's anticipated fair value.

Brookfield advised the Conflicts Committee of its desire to participate up to its pro rata portion of the equity offering and willingness to backstop part of the equity offering. In what in hindsight appears to have been a crucial mistake, the Committee decided not to immediately retain its own independent financial advisor and instead rely on advice from Barclays Capital, Inc., which was serving as TerraForm's financial advisor.

The Conflicts Committee met twice and, at the end of the second meeting on January 29, 2018, determined that the proposed backstop was advisable and in TerraForm's best interest. The Committee relied on members of TerraForm's management and Brookfield representatives without consulting its own financial advisor.

However, an arrangement where Brookfield served as buyer of last resort, which would only come into play if TerraForm's offering was undersubscribed, would be fair to the company and the minority stockholders — assuming Barclays conducted a commercially reasonable marketing effort.

Under that scenario, with the backstop equal to the public offering price, the market would establish the price per share rather than Brookfield. If the price was too low, the offering would be oversubscribed, and the backstop would never become relevant.

At a subsequent meeting — again, without any assistance from an independent financial advisor — the Conflicts Committee approved a support agreement with Brookfield pursuant to which Brookfield contracted to backstop up to 100% of a $400 million public equity offering if the offering price equaled TerraForm's prior five-day volume-weighted average price of $10.66 per share at that time.

TerraForm and Brookfield also agreed that the pricing, size, and timing of the equity offering, including the decision to use the backstop, would be subject to the prior review and approval of the Conflicts Committee and that the Conflicts Committee would retain an independent financial advisor to provide advice regarding the equity offering. Conditioning the sale of shares to Brookfield upon final approval of the Conflicts Committee strengthens the arm's-length nature of the process and follows best practice.

However, more than a month elapsed before the Conflicts Committee began consulting with its own financial advisor, Greentech Capital.

On February 7, 2018, TerraForm publicly announced its intention to acquire Saeta through a tender offer, along with its expectation to fund the acquisition with $800 million in available liquidity, and the $400 million equity offering.

On May 23, 2018, the full Board met to discuss the equity offering and backstop. The company CEO, who was employed and paid by Brookfield, proposed to the Board that TerraForm raise $650 million, rather than $400 million, through the sale of equity because "the market expected a $650 million total equity offering and that the impact to the returns on the Saeta transaction would not be material." Brookfield was prepared to increase the size of the backstop to cover the entire $650 million.

By that point the tender offer to acquire Saeta was scheduled to expire in only a few days and TerraForm had little time to finalize its financing plan. The TerraForm CEO proposed that if the equity offering presented too much market risk, the full amount would be offered to Brookfield in a private placement at $10.66 per share. At the conclusion of the meeting, TerraForm's Board determined that the Conflicts Committee should consider Brookfield's proposal to increase the size of the backstop to $650 million.

Immediately following the full Board meeting, Conflicts Committee met for the first time with its financial advisor, Greentech, to discuss the information that had been presented. There was no discussion of the proposed private placement and only the discussion of the proposed increase of the equity offering to $650 million and commensurate increase in Brookfield's backstop.

The Conflicts Committee met again the following day. At that meeting, Greentech reviewed with the Conflicts Committee the materials provided the previous day, which revealed that a $650 million equity offering would "significantly reduce returns" and accretion from Saeta acquisition relative to the $400 million offering.

Nonetheless, Greentech advised the Conflicts Committee that it would be "difficult to predict the price at which the equity offering could be executed (and whether it could be executed at a price above $10.66)." Greentech also noted that a backstop covering the full amount of the equity offering "was very beneficial." The Committee approved increasing the backstop to $650 million. As with the previous day's meeting, there was no discussion of a private placement.

The Conflicts Committee did not receive advice concerning whether a private placement with TerraForm's controller was fair or superior to TerraForm's financial alternatives. Nearly all information provided to the Conflicts Committee in the ensuing two-week period was geared toward convincing it to abandon the equity offering in favor of the $650 million private placement exclusively with Brookfield.

Approximately two weeks later, after reviewing a single slide deck from Greentech, and relying largely on the advice of Brookfield, TerraForm's management and Barclays, the Conflicts Committee approved exercising the $650 million backstop in lieu of the equity offering. TerraForm management recommended doing away with the public offering aspect and instead simply selling the entire amount of the proposed offering directly to Brookfield.

Despite the fact that the Conflicts Committee never received advice concerning the private placement with Brookfield, the Conflicts Committee accepted company management's recommendation and approved the full exercise of the backstop — that is, a private placement of $650 million of TerraForm stock with Brookfield at $10.66 per share.

The private placement closed. As a result, Brookfield's economic interest and voting power over the company increased from 51% to 65.3%.

TerraForm used the $650 million received from Brookfield to finance the Saeta acquisition.

Within three weeks after the acquisition closed, TerraForm stock was trading at $11.77 per share, 10.4% above the $10.66 per share private placement price, representing an unrealized profit of $68 million to Brookfield.

However, assuming Brookfield's exercised its contractual preemptive right to purchase its pro rata share of any additional stock offering, Brookfield would have earned, more than $50 million of that profit if the Company had sold the balance of the new shares through a public offering. In addition, raising equity through a private placement to Brookfield rather than a public offering presumably saved the Company substantial underwriting fees and expenses.

In retrospect, the Conflicts Committee should have made greater efforts to implement at least some of the procedural protections contemplated by Kahn v. M & F Worldwide Corp.,⁴ to more clearly establish that the controlling stockholder did not dictate the terms of the transaction and that the Committee exercised real bargaining power at arms-length.

The Conflicts Committee should have hired its own legal and financial advisors as soon as Brookfield suggested it would buy more than its pro rata share of the new equity offering.

The Committee should have received more frequent and detailed briefings from its financial advisor about both the value of the shares, and the Company's other financing options, including other possible purchasers in a private placement.

Arguably, the Conflicts Committee fell short of best practice by not attempting to bargain with Brookfield regarding the price per share and thereby extract additional value for the minority stockholders. Although it is hard to know what really happened, the Delaware Supreme Court's opinion suggests that the Conflicts Committee passively accepted the $10.66 per share, based on the five-day trading average established several months before. According to Brookfield, "the Conflicts Committee received no advice concerning whether a private placement with TerraForm's controller was fair or superior to TerraForm's financing alternatives."⁵

Many professionals familiar with these issues likely would agree that selling the entire offering to Brookfield — and thereby eliminating the expense, delay, management distraction and uncertainty of one of the other financing alternatives — was the Company's best practical option. Brookfield provides a textbook example of a situation where presumably smart, ethical businesspeople become too focused on achieving a strategic goal and meeting operational business challenges, while underappreciating the need to conduct a robust procedural process to independently establish the fairness of the final outcome.

1 Brookfield Asset Management, Inc. v. Rosson, (Delaware Supreme Court Sept. 20, 2021).

2 Tooley v. Donaldson, Lufkin & Jenrette, Inc., 845 A.2d 1031 (Del. 2004).

3 Gentile v. Rossette, 906 A.2d 91 (Del. 2006).

4 Kahn v M & F Worldwide, Inc., 88 A.3d 635 (Del. 2014) (in controller buyouts, the business judgment standard of review will be applied if and only if: (i) the controller conditions the procession of the transaction on the approval of both a Special Committee and a majority of the minority stockholders; (ii) the Special Committee is independent; (iii) the Special Committee is empowered to freely select its own advisors and to say no definitively; (iv) the Special Committee meets its duty of care in negotiating a fair price; (v) the vote of the minority is informed; and (vi) there is no coercion of the minority).

5 Brookfield Asset Management, at *4.