Connecticut Supreme Court rejects minority stockholder claim over down round

An April decision by the Connecticut Supreme Court rejects a claim by minority stockholders of Latex Foam International against the majority stockholders for doing a down round favoring the majority.  The May v. Coffey decision can be found here.

The case was brought by a former COO of Latex Foam after the company did a down round led by the majority shareholders in which the COO did not participate.  (The case footnotes that the COO held stock as part of his executive comp and was partially bought out — after the company and he had arbitration over the shares.  It looks like the Company did not buy him entirely at the time, so he remained a shareholder and thus could bring this lawsuit.  This seems like obvious 20-20 hindsight here, but this case is a good reminder of how closely-held companies should always try to entirely buy out former employees when they leave the company. In my opinion, leaving loose ends like this is always asking for trouble.)

The plaintiffs brought claims against the majority stockholders, the Board and the officers of Latex Foam, alleging breach of fiduciary duty and unjust enrichment.   The trial court dismissed the plaintiffs’ case because they found the claims to be derivative (i.e. they apply to the whole corporation, and not just plaintiff) and needed to have been brought by the corporation, as opposed to the plaintiff.  The Supreme Court agreed and wrote a pretty lengthy decision explaining its reasoning.   The following are a few interesting nuggets from the case:

  • a stock offering at below market value does not result in a separate and distinct harm to individual shareholders.  Existing shareholders suffer an indirect injury, a reduction in the value of their existing shares, which is derived from the unreasonably low offering price of the new shares.

  • the court rejects the notion that the claims are “direct” because the majority shareholders are the ones who benefited from the offering.  The court reasoned that this result should be no different than where a third party (such as in a public offering) would have purchased the shares in the new offering.

  • the court emphasizes throughout the decision that this case is based on Connecticut law, not Delaware.  The court  expressly disagrees with a number of technical points raised by other cases (from the 2nd circuit and from Delaware) cited by the plaintiffs. “It is Connecticut law, not Delaware law, that controls our resolution of this case….As we explained in part I of this opinion, under Connecticut law, …we fail to see how the company’s receipt of less than fair value for its new shares of stock becomes a separate and distinct harm to individual shareholders merely because a controlling shareholder, rather than an independent third party, acquires the offsetting benefits.”

Finally, it is important to note that this case is about standing.  Nowhere does the Court actually address whether the down round would have been an actual breach of fiduciary duty.  However, this decision certainly sets a nice barrier to these types of claims, since they must be brought by the corporation, which retains significant discretion over bringing the claims in the first place.

The facts here definitely favored the defendants.  It looks like the plaintiffs were given the right to participate in the new round on the same terms as the other investors, and therefore could have avoided the dilution that resulted.  This is a reminder that in these circumstances – and we are probably going to be seeing a lot more down rounds in the near future – it may be prudent to make the offering to everyone, even if they don’t have preemptive rights or rights of first refusal.





Tags: ,

Leave a Reply

Please log in using one of these methods to post your comment: Logo

You are commenting using your account. Log Out /  Change )

Google+ photo

You are commenting using your Google+ account. Log Out /  Change )

Twitter picture

You are commenting using your Twitter account. Log Out /  Change )

Facebook photo

You are commenting using your Facebook account. Log Out /  Change )

Connecting to %s

%d bloggers like this: