MARION COSTER v. UIP COMPANIES, INC., STEVEN SCHWAT, and SCHWAT REALTY LLC
No. 49, 2020
IN THE SUPREME COURT OF THE STATE OF DELAWARE
June 28, 2021
Submitted: April 7, 2021. Consolidated C.A. No. 2018-0440. Court Below – Court of Chancery of the State of Delaware.
Before SEITZ, Chief Justice; VALIHURA, VAUGHN, TRAYNOR, and MONTGOMERY-REEVES, Justices, constituting the Court en Banc.
Upon appeal from the Court of Chancery. REVERSED and REMANDED.
Max B. Walton, Esquire (argued), Kyle Evans Gay, Esquire, CONNOLLY GALLAGHER LLP, Wilmington, Delaware; Michael K. Ross, Esquire, Thomas Shakow, Esquire, Serine Consolino, Esquire, Sean Roberts, Esquire, AEGIS LAW GROUP LLP, Washington, D.C.; Attorneys for Plaintiff-Appellant Marion Coster.
Stephen B. Brauerman, Esquire, Elizabeth A. Powers, Esquire, BAYARD, P.A., Wilmington, Delaware; Deborah B. Baum, Esquire (argued), PILLSBURY WINTHROP SHAW PITTMAN LLP, Washington, D.C.; Attorneys for Defendants-Appellees UIP Companies, Inc., Steven Schwat, and Schwat Realty, LLC.
The two equal stockholders of UIP Companies, Inc. were deadlocked and could not elect new directors. One of the stockholders, Marion Coster, filed suit in the Court of Chancery and requested appointment of a custodian for UIP under
Coster filed a second action in the Court of Chancery, claiming that the board breached its fiduciary duties by approving the Stock Sale. She asked the court to cancel the Stock Sale. After consolidating the two actions, the Court of Chancery found what was apparent given the timing of the Stock Sale—the conflicted UIP board issued stock to Bonnell to dilute Coster‘s UIP interest below 50%, break the stockholder deadlock for electing directors, and end the Custodian Action. Ultimately, however, the court decided not to cancel the Stock Sale. According to the court, the UIP board approved the Stock Sale at a fair price and set that price through a fair process. It declined to consider any other aspects of the transaction, reasoning that it was unnecessary to review the Stock Sale under any less rigorous standard of review if the stock issuance passed the most rigorous entire fairness review. Having satisfied entire fairness, the court held that the board did not breach any fiduciary duty owed to Coster.
In this decision, we reverse the Court of Chancery on the conclusive effect of its entire fairness review and remand for the court to consider the board‘s motivations and purpose for the Stock Sale. In a vacuum, it might be that the price at which the board agreed to sell the one-third UIP equity interest to Bonnell was entirely fair, as was the process to set the price for the stock. But “inequitable action does not become permissible simply because it is legally possible.”1 If the board approved the Stock Sale for inequitable reasons, the Court of Chancery should have cancelled the Stock Sale.2 And if the board, acting in
After remand, if the court decides that the board acted for inequitable purposes or in good faith but for the primary purpose of disenfranchisement without a compelling justification, it should cancel the Stock Sale and decide whether a custodian should be appointed for UIP.
I.
A.
We rely on the facts as found at trial.4 Wout Coster,5 Cornelius Bruggen, and Schwat formed UIP Companies, Inc. (“UIP” or the “Company“) in 2007. UIP is a Delaware real estate investment services company composed of three subsidiaries: UIP Asset Management, Inc., UIP General Contracting, Inc., and UIP Property Management, Inc. Part of UIP‘s business involves the principals and third-party equity sponsors investing their own capital into the real estate investments of special purpose entities (“SPEs“).6 SPEs are high-risk, high-reward investments that sometimes require prolonged tie-ups of capital and UIP‘s principals’ personal guarantees to lenders. To mitigate risk, UIP‘s principals created UIP and its subsidiaries to control management and develop SPE properties. During trial, the Court of Chancery heard expert testimony that “[t]he reality behind [UIP‘s structure] is if for some reason [the principals] stopped providing opportunities, the three operating companies down below would ultimately run out of business and actually not be able to continue.”7
At formation, Wout, Bruggen, and Schwat each received one-third of the stock. Bruggen ultimately left UIP and tendered his stock to UIP, leaving Wout and Schwat each with a one-half interest in UIP. UIP had a five-member board of directors composed of Wout, Bruggen, and Schwat plus two UIP employees, Bonnell and Stephen Cox. Bonnell, under the tutelage of UIP‘s principals, rose through UIP‘s ranks to become the principal of UIP Asset Management. Cox also rose through the ranks to become chief financial officer at UIP Asset Management.
In late 2013, Wout told the other UIP principals that he had been diagnosed with leukemia. The UIP principals began succession planning, which included de-equitizing Wout. By early 2014, Wout began negotiations with Schwat for a buyout of his UIP stake by Bonnell and Heath Wilkinson, then-president of UIP General Contracting.8 Emails at the time show that Schwat expressed concerns about a lack of liquidity to repurchase Wout‘s stock. Schwat was also concerned that the operating companies were only valuable to UIP executives, such as Bonnell and Wilkinson.
On April 11, 2014, Wout, Schwat, Bonnell, and Wilkinson signed a term sheet
Wout passed away on April 8, 2015. Coster inherited ownership of Wout‘s UIP stock and certain promote entities. Buyout discussions resumed in June 2015 but did not lead to an agreement. In December 2015, Coster sought assistance from Michael Pace—a retired attorney and friend of Coster.10 Pace sent an email to Robert Gottlieb, Wout‘s personal legal counsel, explaining that Coster was “very distressed about her financial situation and now must sell her home.”11 In early 2016,
Gottlieb met with Bonnell and Schwat to negotiate and try to understand the terms of buying out Coster‘s stake in the Company. In March 2016, Schwat emailed Coster directly to convince her to accept his terms. By May, Coster appeared primarily interested in a lump-sum buyout or arrangement that would provide her with a consistent stream of income, but negotiations stalled again.
At the suggestion of Pace, Coster and Anne Pace—Pace‘s wife—met separately with Bonnell in July 2016. More meetings occurred in September and October. The meetings were “very cordial discussions” and, according to Pace, Bonnell was interested in a resolution agreeable to all.12 During the July meeting, Bonnell identified three avenues for the buyout, which Pace forwarded to Michael Rinaldi—UIP‘s previous in-house accountant who had at that time left UIP and served Coster in his individual capacity. Rinaldi told Pace to “push for accounting records on [the operating] companies and exercise all rights as a shareholder.”13 Pace then requested from Bonnell information on the operating companies’ profitability. Bonnell replied that the companies were operating “close to even” without “much positive revenue generated” since Wout‘s passing.14 Pace was skeptical whether this reflected the operating companies’ profitability.
In September 2016, Coster met with Bonnell and Pace.15 Bonnell offered to buy Coster‘s UIP interest while Coster would retain her interest in the promotes. Thereafter, Coster asked Rinaldi to estimate UIP‘s value. Rinaldi thought that a reasonable starting point was the $2.125 million from the Term Sheet, though the Term Sheet included promote interests. Coster then requested that Rinaldi perform a valuation
Scott finalized his valuation in June 2017. Coster‘s counsel sent a letter to Schwat, Bonnell, and Wilkinson enclosing the Scott valuation. In August 2017, Coster sent a letter with the Scott valuation attached and demanded to inspect UIP‘s books and records. After much back and forth about the adequacy of the documents provided, on April 4, 2018, Coster called for a UIP stockholders special meeting to elect new board members. UIP‘s bylaws permit special meetings of stockholders “for any purpose or purposes” upon the written request of stockholders comprising more than 25% of the Company‘s voting stock.17 UIP had not held an election of directors or annual stockholder meeting since 2007. The stockholders never filled the board seats previously held by Bruggen and Wout. Thus, those seats were open. UIP issued a notice of special meeting of stockholders “t[o] vote on the election of directors of the Corporation.”18
On May 22, 2018, the two stockholders and their representatives gathered for the meeting. Thomas Shakow, Coster‘s counsel, represented her by proxy. Serine Consolino, another attorney from the same law firm as Shakow, also attended for Coster. Schwat attended as the representative of Schwat Realty, LLC, through which Schwat holds UIP stock. Jeffrey B. Grill, an attorney, attended as counsel to UIP and served as secretary and inspector of elections. Shakow raised three motions on Coster‘s behalf at the meeting. First, Coster moved to reduce board seats from five to four. Schwat voted against the motion guaranteeing its failure. Next, Coster moved to fill the seats formerly held by Bruggen and Wout with two of Coster‘s designees. This likewise failed. Third, Coster raised a motion to vote on the entire five-member board, nominating Coster, Schwat, Bonnell, and Coster‘s two designees. Schwat adjourned the meeting prior to considering the third motion because “correspondence from [Coster‘s law firm] suggested two proposals to be taken at the special meeting.”19 Schwat “noted that the Company would be happy to consider a request for another special meeting.”20 That same day, Coster called another special meeting to vote on the holdover director seats. UIP agreed to the meeting, but informed Coster‘s attorneys that the board had reduced the number of board seats to three through unanimous written consent.
The two stockholders convened another meeting on June 4, 2018. Shakow, Consolino, and Schwat again attended as representatives for the two UIP stockholders. Grill served as secretary and inspector of elections. Schwat first proposed approval of the elections of Schwat, Bonnell, and Cox to serve as directors until UIP‘s next annual meeting or until their successors are duly elected and qualified. Coster voted against this proposal by proxy, so it failed. Shakow then proposed a vote to
Coster filed this litigation on June 15, 2018 as a statutory proceeding under
On July 16, 2018, the defendants hired Andy Smith of McLean Group LLC to value UIP. The defendants pushed Smith to prepare the valuation prior to the July 27 extended deadline for responding to Coster‘s complaint.23 Then, on advice of counsel, the defendants changed course and decided to answer the complaint while they worked on the Stock Sale. The defendants answered the complaint on July 27, 2018, opposing appointment of a custodian.
On July 27, 2018, McLean provided the board with its preliminary valuation of UIP. Having filed the answer to the Custodian Action complaint with an intent to amend, Schwat informed McLean via email “not to hurry the project ‘in any way,’ even if it meant taking additional time to arrive at ‘the value [they] think is truly fair.‘”24 Schwat “then further suggested adding additional commentary to the report that could justify a lower valuation.”25 McLean issued its final valuation (the “McLean Valuation“) on August 14, 2018. The McLean Valuation valued a 100-percent, noncontrolling equity interest in UIP at $123,869.
On the same day, Schwat forwarded the McLean Valuation to Bonnell and offered to sell him one-third of UIP‘s authorized—but unissued—stock at one-third the value of the McLean Valuation. Bonnell accepted. On August 15, 2018, the board, by unanimous written consent, sold the one-third interest to Bonnell Realty LLC for $41,289.67. On August 15, 2018, equipped with Bonnell‘s one-third interest in UIP, the defendants filed an amended answer in the Custodian Action and stated an intention to move for judgment on the pleadings because the Custodian Action was moot. On August 22, 2018, the plaintiff filed a second action, individually and on behalf of UIP, to cancel the Stock Sale and to impose a constructive trust. Coster alleged that the dilutive Stock Sale interfered with her voting rights and impeded her statutory right to seek court appointment of a custodian. The parties stipulated to consolidation
B.
Before its substantive analysis, the Court of Chancery made factual findings relevant to this appeal. The court found that the defendants “obviously desired to eliminate [Coster]‘s ability to block stockholder action, including the election of directors, and the leverage that accompanied those rights.”26 The court also found that the timing of the Stock Sale and the defendants’ amended answer in the Custodian Action “make clear that the Stock Sale was significantly motivated by a desire to moot the Custodian Action.”27 Further, the court found that Schwat and Bonnell were interested in the transaction.28 The court tempered its findings, however, by noting that the defendants were also concerned about the effects a custodian appointment might have on UIP. According to the court, the board felt that court appointment of a custodian might trigger UIP‘s default under its SPE contracts. And the court found that the stock issued to Bonnell was meant to fulfill a longstanding commitment to give a valuable employee an equity interest.
The court set aside these factual findings, however, and reviewed the Stock Sale under an entire fairness standard of review.29 In the court‘s view, if the Stock Sale passed entire fairness review, the board‘s motives were “beside the point.”30
Looking first at whether entire fairness was the right standard of review, the Court of Chancery concluded that Bonnell and Schwat—a majority of the board—were interested in the transaction. Bonnell conceded interestedness “because he received a benefit as the recipient of the stock that was approved.”31 Schwat viewed the Custodian Action as “invasive” and “wished to avoid” the prospect of a custodian.32 Moreover, the court noted Schwat and Bonnell‘s friendship and that “from the inception of Wout‘s transition planning negotiation, Schwat and Bonnell appeared to be aligned in negotiations against Wout.”33 Schwat and Bonnell “worked together to develop the plan to moot the Custodian Action and neutralize the threat of [Coster] controlling the Company.”34 Thus, the court concluded that Schwat was interested in the Stock Sale because the Stock Sale placed stock in friendly hands to “quash[] any risk, however minimal, of th[e] Court [of Chancery] ordering the expansive relief [Coster] sought in the Custodian Action and mitigated any pressure from [Coster] at the Board level.”35 Having found a majority of the board interested in the Stock Sale, the court held that the defendants had to prove that the Stock Sale was entirely fair to Coster.
The court found that, although the process behind the Stock Sale “was by no means optimal,”36 the McLean Valuation and Smith‘s testimony were credible, which led the court to conclude that the price had been set after a fair process. The court also found the lack of a board meeting did not taint the process because “[i]t
II.
Coster argues on appeal that the Court of Chancery erred when it found that the UIP board did not breach its fiduciary duty to Coster by approving the Stock Sale. According to Coster, the court erred by limiting its inquiry to entire fairness. Instead, the court should have reviewed not just the fairness of the price and process to reach that price, but also the context in which the Stock Sale occurred—a conflicted board approved the Stock Sale to defeat Coster‘s voting rights and the leverage that came from the exercise of those rights, entrench the existing board, and interfere with her statutory right to petition for court appointment of a custodian. As Coster claims, in the context of stalled buyout negotiations, a contested director election and request to appoint a custodian, even though the board had the legal authority to issue UIP stock, the board could not act inequitably by approving the Stock Sale in order to dilute her ownership interest, defeat her voting and statutory rights, and entrench themselves in office. And even if the board had innocent reasons for the Stock Sale, it is undisputed that the Stock Sale interfered with Coster‘s statutory and voting rights. Under these conditions, the board had to prove that it had a compelling justification for the stock issuance, which it failed to do.
The defendants respond that entire fairness review was the appropriate lens to review the Stock Sale because, as the court held, it is the most rigorous standard of review of board action. If the Stock Sale met this standard, the board could not breach its fiduciary duty to Coster under a less rigorous standard of review. They also contend that, even if the Stock Sale interfered with Coster‘s voting and statutory rights, the board had compelling reasons to do so. The directors needed to head off a possible default if the court appointed a custodian, and the board was simply following through on a long-standing promise to reward Bonnell for his service to UIP and retain him as a key UIP employee.
Whether the Court of Chancery applied the correct standard of review is a question of law we review de novo.38 We review the Court of Chancery‘s factual findings for clear error.39
A.
Even though Coster attacks the court‘s entire fairness analysis, the Court of Chancery fully supported its factual findings and legal conclusion that the board sold UIP stock to Bonnell at a price and through a process that was entirely fair. Thus, we will not disturb this aspect of the court‘s decision. But the court also held that its entire fairness analysis was the end of the road for judicial review. In the court‘s words, “[b]ecause the Stock Sale satisfies Delaware‘s most onerous standard of review, this decision does not reach Plaintiff‘s alternative arguments.”40
As early as Schnell v. Chris-Craft Industries, Inc., we recognized that a board of directors could not escape judicial review of its actions by pointing to the legal authorization to undertake a given act.41 In Schnell, the incumbent board took admittedly legal action to move up the annual meeting date and change the location from New York City to a remote destination. These moves prevented a dissident slate from waging an effective election campaign. We held that the board‘s purposeful manipulation of the election machinery to entrench themselves violated the board‘s duty to act equitably toward stockholders. In a recent decision, we captured the essence of Schnell and the twice-tested judicial review of director action affecting the stockholder franchise:
This Court has long recognized that “inequitable action does not become permissible simply because it is legally possible.” Under Delaware law, “director action[s] [are] ‘twice-tested,’ first for legal authorization, and second [for] equity.” “Stockholders can entrust directors with broad legal authority precisely because they know that that authority must be exercised consistently with equitable principles of fiduciary duty.”42
Delaware law recognizes that the stockholder franchise is the “‘ideological underpinning’ upon which the legitimacy of the directors managerial power rests.”43 Keeping “a proper balance in the allocation of power between the stockholders’ right to elect directors and the board of directors’ right to manage the corporation is dependent upon the stockholders’ unimpeded right to vote effectively in an election of directors.”44 “Accordingly, careful judicial scrutiny will be given [to] a situation in which the right to vote for the election of successor directors has been effectively frustrated and denied . . . .”45
Delaware courts “have remained assiduous in carefully reviewing any board actions designed to interfere with or impede the effective exercise of corporate democracy by shareholders, especially in an election
either to frustrate or completely disenfranchise a shareholder vote. . . . [t]here can be no dispute that such conduct violates Delaware law.”47
For instance, in Condec Corp. v. Lunkenheimer Co.,48 the Court of Chancery cancelled a hastily put together stock issuance where the “primary purpose” was to thwart a majority stockholder‘s control.49 The court emphasized the need to protect the stockholder‘s franchise:
the transaction here attacked . . . was clearly unwarranted because it unjustifiably strikes at the very heart of corporate representation by causing a stockholder with an equitable right to a majority of corporate stock to have his right to a proportionate voice and influence in corporate affairs to be diminished by the simple act of an exchange of stock which brought no money into the Lunkenheimer treasury . . . and which was obviously designed for the primary purpose of reducing Condec‘s stock holdings in Lunkenheimer below a majority.50
In Canada Southern Oils, Ltd. v. Manabi Exploration Co., Inc.,51 even though the corporation was in “dire financial plight,” the court considered the circumstances surrounding the stock issuance and held that “the primary purpose behind the sale of these shares was to deprive plaintiff of the majority voting control” and enjoined the transaction.52 And in Packer v. Yampol,53 the court enjoined a preferred stock
issuance meant to defeat a proxy contest.54 Although the company needed to raise capital, and raising capital might have been one purpose for issuing stock, “their primary purpose was to obstruct plaintiffs’ ability to wage a meaningful proxy contest in order to maintain themselves in control.”55
Chancellor Allen summarized the import of these cases in Glazer v. Zapata Corp.:
These cases stand for the proposition that directors may not act to frustrate the efforts of stockholders to elect new directors by engaging in transactions that are designed and pursued for the primary purpose of diluting the votes held by the insurgent stockholders. As such they are articulations of the principle which was old and well established when articulated in Schnell v. Chris Craft Industries, . . . that “the subversion of corporate democracy by manipulation of corporate machinery will not be countenanced under Delaware law.”56
the primary purpose of interfering with or impeding the effectiveness of the stockholder vote in a contested election for directors.”61
Delaware courts will also closely scrutinize transactions that impede a stockholder‘s exercise of a statutory right relating to the election of directors. In Phillips v. Insituform of North America, Inc.,62 the Class B stockholders sought to enjoin a merger because the board issued new stock to deprive a receiver of the ability to act by written consent to replace the board. The court concluded that, when the corporation acts “solely or primarily for the express purpose” to deprive a stockholder of “effective enjoyment of a right conferred by law,” “the board [must] demonstrate that the action taken was fair or justified given the particular business purpose sought to be achieved and the circumstances of the firm.”63
duty.64 And under Blasius, even if the court finds that the board acted in good faith when it approved the Stock Sale, if it approved the sale for the primary purpose of interfering with Coster‘s statutory or voting rights, the Stock Sale will survive judicial scrutiny only if the board can demonstrate a compelling justification for the sale.65 That the court found the Stock Sale was at an entirely fair price did not substitute for further equitable review when Coster alleged that an interested board approved the Stock Sale to interfere with her voting rights and leverage as an equal stockholder.66
B.
On appeal we believe the following undisputed facts or facts found by the court support the conclusion, under Schnell, that the UIP board approved the Stock Sale for inequitable reasons:
- The Stock Sale occurred while buyout negotiations stalled between UIP‘s two equal stockholders;
- The stockholders could not elect a new board because of the deadlock, which led to the Custodian Action;
- A majority of the board members approving the sale were interested in the Stock Sale;
- Schwat and Bonnell were friends and “from the inception of Wout‘s transition planning negotiation, Schwat and Bonnell appeared to be aligned in negotiations against Wout;”67
- Schwat and Bonnell “worked together to develop the plan to moot the Custodian Action and neutralize the threat of [Coster] controlling the Company;”68
- The defendants were “in a rush for the [McLean] [V]aluation”69 until the
defendants “determined to answer the [plaintiff‘s] complaint and then subsequently amend the answer after the sale of stock to Bonnell was completed[,]”70 which permitted them to “file[] an amended answer, which stated an intention to move for judgment on the pleadings because the Custodian Action had been mooted by the Stock Sale;”71 - The Stock Sale put UIP stock in the hands of fellow board member Bonnell, who was aligned with the holdover board;
- The Stock Sale entrenched the existing board in control of UIP; and
- “Defendants obviously desired to eliminate Plaintiff‘s ability to block stockholder action, including the election of directors, and the leverage that accompanied those rights.”72
We recognize, however, that the court made other findings inconsistent with this conclusion.73 Given our deferential standard of review on appeal for the Court of Chancery‘s factual findings, the court should have an opportunity to review all of its factual findings in any manner it sees fit in light of its new focus on a Schnell/Blasius review.
III.
The judgment of the Court of Chancery is reversed, and the case is remanded for further proceedings. Jurisdiction is not retained. We note that, if the Court of Chancery on remand considers appointment of a custodian, under
more complete record the appointment of a custodian will breach agreements or otherwise harm the corporation.75