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Garfield Takes a Bite of the Business Judgment Rule: Delaware Chancery Court Rejects Dismissal of "Control Group" Claim in "Up-C" Structure

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On December 20, 2019, the Court of Chancery of the State of Delaware (the "Chancery Court"), held that the pre-IPO owners in an "Up-C" structure, which typically hold interests directly in the operating subsidiary rather than through the parent corporation, may, in certain circumstances, be deemed a "control group" even if otherwise unaffiliated. In Garfield v. BlackRock Mortgage Ventures, LLC, et al. No. 2018-0917 (Del. Ch. Dec. 20, 2019), the Chancery Court denied a motion to dismiss a stockholder challenge to the fairness of a reorganization from an Up-C structure to a simple corporate form, reasoning that the stockholder had adequately pleaded the existence of a control group among various institutional investors taking the Up-C public. Because the complaint supported a reasonably conceivable inference that two large stockholders constituted a control group that stood to benefit from the reorganization, the Chancery Court refused to apply the less onerous standard of review under the Delaware Supreme Court's Corwin v. KKR Financial Holdings, 125 A.3d 304 (Del. 2015), known as the business judgment rule. The ruling in Garfield could have ramifications for sponsor groups using the Up-C structure to take a historical partnership public, as the sponsor group could be found to together have a controlling interest in the Up-C, even when they own less than a majority of the voting rights or have rights to designate less than a majority of the board of directors.

During the financial crisis of 2008, BlackRock, Inc. ("BlackRock") and Highfields Capital Management ("HC Partners") formed an entity, PennyMac, LLC, to acquire mortgages from financial institutions that were seeking to reduce their exposure. In 2013, BlackRock, HC Partners, and the former PennyMac, LLC chief executive officer took the overall structure public in an "Up-C" transaction, whereby a newly-formed public holding corporation ("PennyMac, Inc.") sat above PennyMac, LLC, the operating subsidiary. Public stockholders owned 15% of the voting rights and 100% of the economic rights in PennyMac, Inc. (via Class A common stock), while the pre-IPO owners of PennyMac, LLC, including PennyMac management, BlackRock and HC Partners (the "LLC Unitholders"), owned 85% of the voting rights in PennyMac, Inc. (via Class B common stock) and economic interests in PennyMac, LLC (via LLC units), but owned no economic rights in PennyMac, Inc. directly. After the passage of the Tax Cuts and Jobs Act of 2017 and changes in PennyMac's business, the diminished benefits of an "Up-C" corporation led the board of directors of PennyMac (the "PennyMac Board") to instruct management to discuss reorganization options with the holders of Class B common stock (who were the LLC Unitholders). The reorganization was designed to allow the LLC Unitholders to exchange their LLC units for PennyMac Class A common stock in a tax-free exchange and to receive long-term capital gains treatment on future sales of such stock. The PennyMac Board eventually established a special committee to evaluate the reorganization. The special committee recommended that the PennyMac Board approve the reorganization, which the PennyMac Board subsequently did. After the PennyMac Board's initial approval, HC Partners and BlackRock sought, and the PennyMac Board approved, a new provision requiring HC Partners' and BlackRock's consent to terminate the reorganization before the effective date. Approval of the reorganization required a majority vote of the PennyMac stockholders.

After PennyMac's stockholders approved the reorganization and it closed, a holder of Class A common stock brought breach of fiduciary duty claims against BlackRock, HC Partners, and PennyMac directors who did not serve on the special committee, each of whom owned more LLC units in PennyMac, LLC than shares of Class A common stock in PennyMac, Inc. The plaintiff argued that the reorganization created benefits for those defendants who held interests directly in the operating subsidiary, PennyMac, LLC, but not for the stockholders who held their interests only in the parent corporation, PennyMac, Inc. The defendants moved to dismiss the claims, arguing that they should enjoy the benefit of the business judgment rule under Corwin because a majority of disinterested stockholders approved the transaction.

In its Corwin decision, the Delaware Supreme Court ruled that a business judgment standard applies to corporate actions that show uncoerced approval by a fully informed majority of disinterested stockholders. Under this standard, deference is given to the board of directors' business judgment unless the board is conflicted in some way or failed to act in good faith or loyalty to the company.

The Chancery Court concluded that Corwin did not apply because the plaintiff adequately pleaded facts sufficient to form a reasonably conceivable inference that BlackRock and HC Partners formed a control group that exercised effective control over PennyMac in connection with the reorganization. As a result, the more onerous entire fairness standard of review applied at the pleading stage. Entire fairness review requires greater scrutiny as to the fairness of dealings leading up to a transaction and aspects of the transaction itself, including pricing and financial terms. To determine whether the complaint adequately pleaded a claim under the entire fairness standard, the Chancery Court looked for both transaction-specific facts suggestive of an agreement, as well as historical facts indicting that the defendants had agreed to coordinate in the past. Together, BlackRock and HC Partners controlled 46.1% of the vote, had board representation, and had consent rights over the reorganization; thus, the Chancery Court held that if they acted together, they had control. The critical question was whether they had, in fact, agreed to act in concert, or whether they simply had concurrent, but independent, interests in the reorganization. The Chancery Court concluded that BlackRock's and HC Partners' long history of coordinated involvement with PennyMac, coupled with their critical roles in approving the reorganization, created an inference of concerted action. As a result, the Chancery Court held that the plaintiff had plausibly alleged the presence of a controlling group, and Corwin did not apply at the pleading stage.

This case could have ramifications for defendants relying on the business judgment rule and the the standard of review established by Corwin. For example, the Chancery Court notably followed two recent Delaware decisions that identified "historical" ties as a factor to consider when determining whether an agreement existed among putative members of a control group (Sheldon v. Pinto, 2019 WL 4892348 (Del. Oct. 4, 2019) and In re Hansen Medical Shareholders Litigation, 2018 WL 3025525 (Del. Ch. June 18, 2018)). But in those cases, the courts demanded that plaintiffs identify multiple investments in multiple companies and otherwise refused to infer an agreement. In Garfield, by contrast, the Chancery Court concluded that the plaintiff had adequately pleaded historical ties simply by virtue of the defendants' investment in a single company. The Chancery Court concluded that the plaintiff had alleged facts sufficient to infer that BlackRock and HC Partners were a "control group," as well as facts sufficient to question whether the reorganization was entirely fair.

To read more about Garfield v. BlackRock Mortgage Ventures, LLC, et al. No. 2018-0917 (Del. Ch. Dec. 20, 2019), click here.

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