INSIGHT: The Rapid Demise of Gentile Picks Up (Even More) Speed

The Delaware Supreme Court sparked controversy with its 2006 decision in Gentile v. Rossette when it held that a stockholder could bring a direct (rather than derivative) overpayment claim against a controlling stockholder where the controller engages in a conflicted transaction that extracts economic and voting power from the minority.

Prior to Gentile, a stockholder could assert overpayment claims only derivatively, thus facing additional hurdles, particularly in situations where the relevant transaction merged out the minority stockholders. After Gentile, the possibility of a post-merger lawsuit remained alive.

In Carsanaro v. Bloohound and Nine Systems Corporation Shareholders Litigation, the Delaware Court of Chancery initially extended Gentile beyond the controlling stockholder context to situations where there was a conflicted majority of the board of directors.

According to these cases, “it ma[de] little sense to hold a controlling stockholder to account to the minority for improper expropriation after a merger but to deny standing for stockholders to challenge a similar expropriation by [a conflicted] board of directors after a merger.” These decisions were unmoved by fear of the Gentile exception “swallow[ing] the general rule” that dilution claims were derivative.

In 2016 in El Paso Pipeline GP Co. LLC v. Brinckerhoff, the Delaware Supreme Court likely brought an end to this expansive view of Gentile. El Paso involved a classic derivative overpayment claim alleging that a committee of the board had approved a transaction that favored the limited partnership’s general partner over the best interests of the limited partnership itself.

After the trial, the partnership merged with another company, thereby cashing out each of the limited partner’s interests in the partnership. The Court of Chancery subsequently awarded plaintiff a $171 million judgment finding that plaintiff’s claims were direct or, even if not, should be permitted to proceed because dismissal would leave plaintiff without recourse for the general partner’s unfair dealing.

The Delaware Supreme Court reversed, holding that the misappropriation was not “coupled with any voting rights dilution” as is required to state a direct claim under Gentile. In doing so, the El Paso Court reasoned that extending Gentile beyond its facts would “largely swallow the rule that claims of corporate overpayment are derivative by permitting stockholders to maintain a suit directly whenever the corporation transacts with a controller on allegedly unfair terms.”

Such an extension would also “raise overall transactions costs and barriers to mergers, with obvious costs to public investors, with no gain substantial enough to compensate them.”

Significantly, the court made no attempt to explain why its concern about transaction costs did not apply equally to Gentile’s exception to treating overpayment claims as solely derivative or why the bad acts Gentile was intended to address were any more egregious than those alleged in El Paso, which, even in reversing, the Delaware Supreme Court referred to as “troubling.”

Using the court’s own framework, it is difficult to understand why whatever benefit might be gained by permitting what are essentially derivative claims for dilution to survive a merger is not outweighed by the potential dangers such lawsuits pose to the very public investors which they purport to help.

In a similar vein, Chief Justice Leo E. Strine Jr., in a concurring opinion, wrote that there was no legal justification for the Gentile exception and that the decision “ought to be overruled.”

El Paso precipitated a major course correction by the Court of Chancery, which has now strictly limited Gentile to its facts, even on issues that El Paso did not address, and rejected the reasoning of Carsanaro and Nine Systems Corp.

Recent Decisions

Two recent decisions from the Court of Chancery—Klein v. H.I.G. Capital LLC (Dec. 19, 2018) and Reith v. Lichtenstein (June 28, 2019)—take El Paso even farther, finding that overpayment claims could not be direct even where all of the Gentile factors—a controlling stockholder and both economic and voting harm—are present.

The cases involved alleged overpayment claims related to the issuance of voting preferred stock to controlling stockholders on unfair economic terms. The preferred stock voted with the common stock and the court assumed that proportional voting harm sufficient to satisfy Gentile was present.

Nevertheless, the Court of Chancery declined to apply Gentile on the grounds that the economic harm suffered was not the same type of economic harm alleged in Gentile. In Gentile, the economic harm was a direct result of the dilution of the aggregate ownership percentage of the minority common stockholders.

In contrast, the economic harm alleged was caused by the issuance of “a different type of security”—voting preferred stock—“whose terms allegedly should have commanded a higher price than was paid.”

So while Gentile was an expanding doctrine in the Court of Chancery as recently as 2014, it has been dramatically curtailed in recent years and may be overruled by the Delaware Supreme Court. The rationale to overrule has already been outlined in El Paso and the state’s high court seems just to be waiting for the right case to come before it.

In the interim, the Court of Chancery will continue to view efforts to assert post-merger overpayment claims directly with skepticism.

This column does not necessarily reflect the opinion of The Bureau of National Affairs, Inc. or its owners.

Author Information

Jonathan Rotenberg is a partner in Katten’s Litigation practice. He defends public companies and financial institutions of all kinds, as well as businesses spanning industries from energy to home furnishings to pharmaceuticals, against claims brought under the Securities Act of 1933, the Securities Act of 1934, and other federal and state securities laws.