Albert H. Manwaring IV.

Dilution claims are "classically derivative" under Delaware corporate law. In Gentile v. Rossette, 906 A.2d 91 (Del. 2006), the Delaware Supreme Court recognized an exception that dilution claims can be both derivative and direct in character when: "a stockholder having majority or effective control causes the corporation to issue 'excessive' shares of its stock in exchange for assets of the controlling stockholder that have a lesser value; and the exchange causes an increase in the percentage of the outstanding shares owned by the controlling stockholder, and a corresponding decrease in the share percentage owned by the public (minority) shareholders."

To avoid demand futility and standing requirements for a derivative claim, the plaintiff stockholders in Sheldon v. Pinto Technology Ventures, No. 81, 2019 (Del. Oct. 4, 2019), attempted to plead a direct claim for dilution of their voting and economic interests by alleging that several venture capital firms constituted a "control group" of stockholders under Gentile.

The Delaware Supreme Court ruled in Gentile that multiple stockholders can constitute a "control group" if they are connected in some legally significant way, such as by contract or other agreement, or working together toward a shared goal.

In Sheldon, the Delaware Supreme Court affirmed the Delaware Court of Chancery's dismissal of the alleged direct claim for dilution of the voting and economic interests of plaintiff stockholders because plaintiffs failed adequately to plead that the venture capital firms constituted a "control group." To begin its analysis, the court noted the guideposts that define a "control group" established by In re Hansen Medical Stockholders Litigation, (Del. Ch. June 18, 2018), and van der Fluit v. Yates, (Del. Ch. Nov. 30, 2017). In Hansen, two individuals and their affiliated entities had a 21-year history of coordinating investments in at least seven different companies, and had declared themselves to the SEC as a "group of stockholders." When the stockholders in Hansen invested in the company at issue, they were the largest stockholders and negotiated certain terms in a merger agreement that were not shared by minority stockholders. Relying upon the 21-year investment history in Hansen, the Court of Chancery found that the stockholders were controllers. By contrast in van der Fluit, the plaintiff alleged that a group of tech industry entrepreneurs and venture capital firms comprised a control group that controlled certain members of the board. But, the only legally significant connection that the van der Fluit plaintiff cited was two shareholders agreements, to which the entrepreneurs and venture firms were parties. Notably, however, other shareholders that were parties to those shareholder agreements were not alleged to be part of the control group in van der Fluit. On these facts, the Court of Chancery found that the plaintiff's allegations were insufficient to establish the existence of a "control group."

Here, in contrast to a 21-year coordinated-investment history by the stockholder control group in Hansen, the court held that the stockholders being parties to a voting agreement and periodically investing in the same companies in the past was more like the control group allegations in van der Fluit, which were insufficient to establish the existence of a "control group." The court pointed out that, unlike the voting agreement in Hansen, the voting agreement here only required the parties to vote together to select certain directors, but did not require the parties to vote together on any transaction, including the allegedly dilutive transactions. Turning to the alleged common investment history, the court emphasized that the complaint identified only four companies, in which two or more of the three stockholders shared investments, and the plaintiffs failed to identify a single company, in which all three stockholders were alleged to be part of the control group that had invested. Additionally, plaintiffs did not allege that other investors that received the same rights as the defendant stockholders in the dilutive financing were part of the "control group." Without more, the court explained that the plaintiffs' "allegations merely indicate that venture capital firms in the same sector crossed paths in a few investments."

In sum, the plaintiffs failed adequately to plead the existence of a "control group" to support a direct claim for dilution. Accordingly, because the plaintiffs had not made a pre-suit demand upon the board or pleaded demand futility for a derivative claim, the court affirmed the dismissal of the action with prejudice.

Albert H. Manwaring IV ([email protected]) is a corporate governance and fiduciary litigation partner at Morris James in Wilmington.