U.S. M&A Newsletter — March 2024

In In re Sears Hometown and Outlet Stores, Inc. Stockholder Litigation (Jan. 24, 2024), the Delaware Court of Chancery held that a controlling stockholder must not, intentionally or with gross negligence, harm a corporation or minority stockholders when affirmatively exercising their stockholder voting rights to change the status quo of the corporation. Following the broader analysis of the sale of Sears Hometown and Outlet Stores, Inc. (the “Company”) to its controlling stockholder, Edward Lampert, Vice Chancellor J. Travis Laster ultimately found a breach of “limited” fiduciary duties and awarded damages of approximately $18 million.

Background

Lampert, through his investment firm, controlled the Company by holding more than 50% of the Company’s publicly traded stock. The Company had two separate business segments, one of which (“Hometown”) was in financial distress and the other (“Outlet Stores”) more profitable.

The Company’s Board of Directors and its Special Committee, formed to explore either a potential sale to Lampert or a bankruptcy-related transaction, concluded that unless Lampert agreed to increase his proposed price for the Company, liquidation of Hometown was the best option. 

Lampert believed that such a liquidation would destroy the Company’s value and so as the majority stockholder, acting by written consent, he:

• amended the Company’s bylaws to require that liquidation of Hometown receive approval from 90% of the Board, taken at two separate Board meetings at least 30 business days apart (with the Board disclosing the results of the first meeting to stockholders if the liquidation was approved), and
• replaced two Board members who served on the special committee and who Lampert saw as an impediment to a deal (such two actions, the “Controller Intervention”).

As liquidation became impracticable, the Special Committee (which now only consisted of one member) resumed negotiations with Lampert. Lampert and the Company entered into a merger agreement pursuant to which Lampert acquired the Company without Outlet Stores for $2.25 per share. The Company then solicited third-party bids for Outlet Stores that eventually were sold to Vintage Capital Management LLC for $121 million, subject to adjustments. Company stockholders received total consideration of $3.21 per share following closing of both parts of the deal, which represented a 76% premium over the Company’s trading price. Minority stockholders challenged the transaction. 

Court’s Analysis

The Court held that (i) Lampert did not breach his fiduciary duties as a controlling stockholder in connection with the Controller Intervention, but (ii) the sale of the Company was not entirely fair and, accordingly, Lampert breached his fiduciary duties with respect to the sale. 

Lampert did not breach his fiduciary duties in the exercise of his stockholder voting power. 

In analyzing a controller’s fiduciary duties, the Court distinguished between two situations in which a controller exercises their powers.

• When a controller uses their “influence over the board and management to wield corporate power indirectly and cause the corporation to act,” the controller is subject to the same fiduciary standards as directors.
• However, when a controller exercises stockholder-level rights only and acts to change the corporation’s status quo, such actions implicate fiduciary duties that are different and more limited than those of directors:
  • If a controller’s stockholder action is in maintenance of the status quo, such action is not subject to fiduciary duty review.
  • But when voting to change the status quo, a controller is required to not harm the corporation or its minority stockholders intentionally (under duty of loyalty) or through grossly negligent action (under duty of care).

The Court applied its intermediate standard of review, enhanced scrutiny, in reviewing the Controller Intervention due in part to a potential conflict in Lampert’s actions. Lampert had to show that he (i) acted in good faith, after a reasonable investigation, to achieve a legitimate objective and (ii) chose a reasonable means for achieving that legitimate objective. 

The Court found that Lampert believed in good faith that the liquidation of Hometown would be detrimental to the Company’s value, the prevention of which was a legitimate objective, and that the Controller Intervention was a reasonable choice of means and not in breach of Lampert’s fiduciary duties.

The sale of the Company was not entirely fair and was in breach of Lampert’s fiduciary duties.

The Court then reviewed the sale of the Company and applied the entire fairness review standard because the transaction involved the controller “acquiring the Company and eliminating the minority stockholders from the enterprise” and was not conditioned on certain upfront protections that could have lowered the applicable standard of review. Lampert therefore had to establish both a fair price and a fair dealing (process) in the transaction.

In finding that the transaction was not entirely fair, the Court focused specifically on the price paid and the deal process relating to Hometown. The Court found that the price for the sale of Hometown resulted in such a substantial control premium to Lampert and discount to the minority stockholders that it was unfair. The Court also found an unfair dealing, with the Controller Intervention as a determining factor. The removal of two directors who also served on the Special Committee resulted in negotiations between Lampert and the Special Committee that did not reflect arm’s-length bargaining. 

The Court found Lampert liable for breach of his fiduciary duties as a controller and awarded damages to the plaintiffs of $1.78 per share, an amount equal to the difference between the Court’s valuation of the Company and the consideration that the stockholders received.

Our Take 

In re Sears explores the difference between (i) a controlling stockholder’s ability to freely vote their shares as they wish without implicating their fiduciary duties, and (ii) a controlling stockholder’s potential liability for actions that change the status quo and may harm the corporation. Controlling stockholders and boards of controlled companies would need to be mindful of this decision and the legal framework it has established, especially with regards to actions by controlling stockholders that may change the status quo and transactions between a controlling stockholder and the corporation, and the steps that can be taken to satisfy the entire fairness standard of review. Lampert’s counsel has filed a motion for reargument with respect to the court’s valuation analysis, which is currently pending.