In the Court of Chancery’s recent opinion, In re EZCorp Inc. Consulting Agreement Derivative Litigation (“EZCorp”), the court grappled with the appropriate standard of review for business transactions between a controlled company and a controlling shareholder. In this extensive opinion, Vice Chancellor Laster confronts the parameters of the Delaware Supreme Court’s holding in Aronson v. Lewis. Ultimately, he found that allegations of self-dealing by a controlling shareholder withstand the entire fairness standard of judicial review and refused to extend the holding in Aronson beyond the demand futility context.
EZCorp is a Delaware corporation with two classes of stock. Holders of Class A stock have no voting rights, while holders of Class B stock retain all of the voting rights. MS Pawn LP, a Delaware limited partnership, owned 100% of the EZCorp Class B stock. Phillip Ean Cohen was the sole owner of stock in MS Pawn LP’s general partner, MS Pawn Corp. Thus, through MS Pawn, Cohen owned 100% of EZCorp’s Class B voting stock through the two MS Pawn entities, which amounted to 5.5% of the company’s equity.
EZCorp had a history of entering into advisory service agreements with Cohen. Between 1996 and 2004, EZCorp entered into agreements with Morgan Schiff, Cohen’s investment firm. The company eventually discovered it overpaid the firm by $400,000. Subsequently, EZCorp decided not to renew the agreements. After terminating the agreements with Morgan Schiff, EZCorp entered into new agreements with Madison Park, another Cohen associated firm. The agreements provided that EZCorp would pay Madison Park $100,000 per month for three years. Starting in 2007, Madison Park’s monthly fee drastically increased each year. In 2011, EZCorp entered into service agreements with Madison Park where the firm received $500,000 per month for its services. The complaint alleged that EZCorp’s Audit Committee “rubber-stamped” the service agreements with Madison Park due to their “cozy positions as directors at Cohen’s company.” The plaintiff alleged that the challenged agreements “were not legitimate contracts for services but rather a means by which Cohen extracted a non-ratable cash return from EZCorp.” Consequently, the “[b]oard could not impartially consider a litigation demand because at least two of the directors . . . were insiders who were not independent from Cohen and Madison Park.”
Before the court parsed the applicable standard of review, it affirmed that Cohen and MS Pawn were proper defendants. The court explained that it is deeply embedded in Delaware law that those who “wield control over the corporation” are subject to breach of fiduciary duty claims.
It is a fundamental concept of corporate law that the management and business decisions rest in the hands of a corporation’s board of directors. Under the business judgment standard, the court presumes that the board “acted on an informed basis, in good faith and in the honest belief that the action was taken in the best interest of the company” while making a business decision. Affirming this concept, the Delaware Supreme Court in Aronson established the demand excusal test to determine whether or not a stockholder derivative suit should survive a Rule 23.1 motion. The Aronson court rejected the plaintiff’s contention that a controlling stockholder dominated the board of directors regarding an employment agreement. The court held that “the entire question of demand futility is inextricably bound to issues of business judgment and the standards of that doctrine’s applicability.”
With Aronson well embedded in Delaware law, the defendants in EZCorp argued that the court should apply the business judgment standard when reviewing the transaction between EZCorp and Madison Park. The defendants reasoned that the parameters of the entire fairness standard apply only to squeeze-out-mergers and not the situation at issue. Vice Chancellor Laster cited several decisions where Delaware courts expressly rejected this argument, as well as decisions where the courts applied the entire fairness framework to a “variety of transactions in which controlling stockholders have received non-ratable benefits.”
Although defendants did not rely on Aronson as a controlling case, the Court of Chancery found that the crux of defendants’ arguments relied on the same principles established in that decision. He noted that In re Tyson Foods, Inc., Friedman v. Dolan, and Canal Capital Corp. By Klein v. French all stemmed from Aronson’s precedent that the business judgment rule is the proper standard of review in situations where the controller receives a benefit from a transaction approved by a “board or duly empowered committee with an independent majority of outside directors.” Noting that there is “tension” within the applicable case law, the court grappled with two issues concerning the application of Aronson. First, it questioned which “policy judgments about the demand futility context were intended to extend to the substantive law that would apply if demand was excused or if the claim was direct.” Second, it questioned which aspects of the Aronson decision were intended to be “immune to further common law development.”
Vice Chancellor Laster explained that Aronson pre-dates many of the key decisions in this area of law, including Unocal Corp. v. Mesa Petroleum Co. and Revlon Inc., v. MacAndrews & Forbes Holdings, Inc., as well as three decades of “development in the law regarding controlling stockholder transactions.” Thus, with these considerations in mind, Vice Chancellor Laster ultimately held that the entire fairness standard applies to transactions where a controlling stockholder obtains a non-ratable benefit. He also suggested that Aronson “limited its analysis to the issue of demand futility.”
The Court of Chancery emphasized that it is ultimately the Delaware Supreme Court’s decision to “apply Aronson more broadly and limit the substantive application of the entire fairness framework.” However, the court explained that case law supported the application of the entire fairness standard. Further, the court highlighted that this decision does not imply that the plaintiff’s claim for breach of fiduciary duties will necessarily be successful. Rather, the plaintiff’s claim survives the Rule 12(b)(6) motion. Ultimately, EZCorp implicates the question whether the Delaware Supreme Court will agree with the Vice Chancellor’s analysis regarding his suggested limitation of Aronson’s application. However, until there is clarity from the Court, companies should be careful when a controlling shareholder obtains a non-ratable benefit from a transaction with the controlled company. Until the affects of EZCorp are discernible, the other option to avoid this type of litigation is to completely forgo transactions with a controlling shareholder.
Helene is a third year student at Widener University Delaware Law School and Senior Staff Member on the Delaware Journal of Corporate Law. Helene is also the Moot Court Honor Society Ruby R. Vale Chairperson. After graduation, Helene will be clerking for the Honorable Calvin L. Scott, Jr. in the Superior Court of Delaware.
Suggested Citation: Helene Episcopo, EZCorp Deems Entire Fairness Standard Appropriate When Controlling Shareholder Receives Non-Ratable Benefits, Del. J. Corp. L (April 23, 2016), www.djcl.org/blog.