In the case of In re Sears Hometown and Outlet Stores, Inc. Stockholder Litigation, the Delaware Court of Chancery, in an opinion delivered by Vice Chancellor J. Travis Laster, provided clarity on the responsibilities of controllers when exercising stockholder rights to change a corporation's current state. It was clarified that controllers have a duty to avoid intentionally or negligently harming the corporation or its minority stockholders when making such changes. If a controller acts in a way that impairs the rights of directors or minority stockholders, the court will subject the action to enhanced scrutiny review. This requires the controller to demonstrate acting in good faith for a valid purpose, having a reasonable basis for believing the action was necessary, and selecting a reasonable method to achieve the objective.
This ruling addressed the previous uncertainty regarding whether controllers owe fiduciary duties solely as stockholders, as opposed to when influencing the board and management. The Sears decision, pending potential appeal to the Delaware Supreme Court, concluded that controllers are indeed bound by fiduciary responsibilities when using their stockholder rights to change the company's status quo. However, it reiterated that controllers are not held to fiduciary duties when they exercise their rights to vote or sell stock to defend themselves against corporate actions and maintain the current state.
Unlike directors' fiduciary duties, controlling stockholders are permitted to act in their self-interest rather than solely in the corporation's best interests. This allowance persists as long as their actions do not intentionally or negligently harm the corporation or its minority stockholders
Background
Sears Hometown & Outlet Stores (the “Company”) operated two distinct businesses, Hometown Stores and Outlet Stores, under the control of Eddie Lampert. Facing significant financial challenges, Hometown Stores prompted the Company to establish a special committee initially tasked with exploring potential transactions with Lampert. Later, the committee's scope expanded to include considerations of any bankruptcy-related transactions. As discussions progressed, both management and the special committee leaned towards favoring a liquidation of Hometown Stores unless a satisfactory deal could be negotiated with Lampert.
However, Lampert held firm in his belief that liquidation would erode value, attributing this stance to what he viewed as overly optimistic projections from management and the special committee regarding potential proceeds. When negotiations with Lampert failed to produce an agreement on terms, and liquidation seemed imminent, Lampert took action through written consent to prevent it. This action included (i) amending the company’s bylaws to mandate a 90% board approval for any Hometown business liquidation, requiring two separate votes at least 30 business days apart (with interim disclosure of the initial vote to stockholders), and (ii) removing two directors from the special committee who had been the most vocal proponents of the liquidation plan.
The Court of Chancery's ruling referred to these measures as the “Controller Intervention.”
With only one member remaining, the special committee concluded that the most feasible path forward was to continue negotiations either for the sale of the Hometown business or for the entire Company. Lampert reached an agreement to acquire the Company, excluding the Outlet Stores, at a price of $2.25 per share. Additionally, Lampert agreed to a process where Outlet Stores would be put up for sale during an 84-day go-shop period, with a predefined floor price and Lampert's right to match any competing offers.
During this go-shop period, a third party successfully purchased Outlet Stores for $121 million, surpassing Lampert’s matching right by $1 million. As a result, stockholders received $2.25 per share from Lampert for all assets except Outlet Stores, and an additional $0.96 per share from the purchaser of Outlet Stores. This amounted to a 76% premium over the Company's trading price. Subsequently, stockholders raised concerns about the transaction.
Court’s Reasoning
In a thorough examination, the Court of Chancery conducted a separate analysis on two key aspects: (i) whether Lampert breached his duties of loyalty or care as a controller in relation to the Controller Intervention, and (ii) the fairness of the Company's sale.
The court resolved conflicting legal precedents and clarified that controllers are indeed bound by fiduciary duties when utilizing stockholder-level authority to make changes to the company's existing state.
Under well-established Delaware law, controllers owe fiduciary duties when they use their “influence over the board and management to wield corporate power indirectly and cause the corporation to act.” According to Vice Chancellor Laster, Lampert’s written consent actions did not implicate that principle because he “only used his powers as a stockholder.”
The court acknowledged “competing strains of authority” on whether Lampert, as a controller, owed fiduciary duties when acting through written consent or using other stockholder rights. The court explained that “[t]he three most familiar” stockholder-level rights “are the rights to sell, vote, and sue.” Addressing the right to sell and the right to vote specifically, the court held that controllers do not owe fiduciary duties when they exercise these rights to defend themselves and preserve the status quo. Controllers do owe fiduciary duties, however, when they decide to sell their shares or vote them in favor of changing the status quo at the company. The attendant standard of conduct is that a controller who “seeks to change the status quo . . . cannot harm the corporation knowingly or through grossly negligent action.”
Enhanced scrutiny applies where the stockholder takes action to impair the rights of directors or the minority stockholders.
Analyzing the actions taken in connection with the Controller Intervention, the court articulated that the applicable enhanced scrutiny standard requires fiduciaries to establish that they “(i) sought to pursue a legitimate end and (ii) selected an appropriate means of achieving it.” Elaborating on this standard, the court explained that fiduciaries “must show that [they] acted in good faith for a legitimate objective and had a reasonable basis for believing that action was necessary.” They also must show that they “selected a reasonable means for achieving [their] legitimate objective.”
In taking the written consent actions to thwart the committee’s plan to liquidate the Hometown Stores, Lampert identified a legitimate objective of “[p]romoting the long-term value of the corporation within the limits of the law for the ultimate benefit of its residual claimants.” The court was satisfied that this was Lampert’s true objective and that he had a reasonable basis to fear that the plan to liquidate Hometown Stores would compromise the Company’s long-term health. The court further found that the written consent actions were a reasonable response to the threat posed by liquidation plan. Although the court acknowledged that Lampert might have achieved the same result through some lesser response (e.g., by removing only one director or only adopting the bylaw amendment), it found that he nonetheless made “a reasonable choice among debatable tactical alternatives.”
The sale of the Company to Lampert and a third party was not entirely fair.
Turning to the two-part sale of the Company, the Court of Chancery applied the entire fairness standard because the transaction “involved Lampert acquiring the Company and eliminating the minority stockholders from the enterprise.” Notably, the Company did not employ MFW procedural protections, and therefore, the burden of proof remained with Lampert, as controller, to demonstrate that the sale of the company was entirely fair.
As to the first prong of the analysis, fair price, the Outlet Stores business was valued at market price, while the valuation of Hometown Stores turned on the amount of net proceeds that its inventory could generate and the related third-party liabilities. The valuation for the liquidation proceeds suggested that Lampert underpaid for Hometown Stores, and that his implied control premium in the transaction was high. Therefore, the court concluded that Lampert failed to pay a fair price in the transaction.
As to the fair process prong of entire fairness, the court evaluated the sale of Hometown Stores to Lampert and the sale of Outlet Stores to the third party as a single transaction. Although evidence about the fairness of the sale process was mixed, it fell “well short of a showing that would be necessary to overcome the fair price dimension.” The court was concerned that Lampert’s written consent actions—though they complied with enhanced scrutiny—left the one-member Special Committee unable to bargain at arm’s length.
The court awarded the plaintiffs damages of $1.78 a share (about $18 million), equal to the gap between the court’s valuation of the Company ($4.99) and the total price of the transaction ($3.21).
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