In Firefighters’ Pension System of the City of Kansas City, Missouri Trust v. Foundation Building Materials, Inc., C.A. No. 2022-0466-JTL (Del. Ch. May 31, 2024), the Delaware Court of Chancery addressed at the motion to dismiss stage numerous claims brought by a stockholder plaintiff against a controlling stockholder, directors under the control of the controller, a special committee, and financial advisors concerning a consummated merger. The court’s lengthy decision underscored its vigilance and interest in protecting minority shareholders from the effects of conflicts of interest, in particular those stemming from a controlling stockholder, that may have an influence on terms of a transaction or whether a transaction should occur at all.
The case revolves around the sale of Foundation Building Materials, Inc. (the Company). The plaintiff sued on behalf of a putative class of minority stockholders alleging, among other things, (i) breaches of fiduciary duties by the Company’s controlling private equity firm, Lone Star, directors controlled by Lone Star, and the special committee formed to consider the sale and (ii) aiding and abetting those breaches of fiduciary duties by the Company’s and special committee’s financial advisors. The fiduciary duty claims related to the sale process and board disclosures to stockholders. The court issued a mixed ruling, granting in part and denying in part six motions to dismiss. The key facts alleged by the plaintiff, which were pleaded following an inspection of books and records, along with the court’s salient rulings are summarized below.
Factual Background
Lone Star acquired the Company in a going-private transaction in late 2015. Eighteen months later, Lone Star took the Company public again through an IPO. In connection with the IPO, the Company and Lone Star entered into a tax receivable agreement (TRA) that was estimated to pay Lone Star between $190 million and $220 million. Lone Star had the right to terminate the TRA, and if it did so in certain circumstances, including in a change of control scenario, it would be entitled to an early termination payment (ETP). The formula to determine the value of the ETP discounted the projected TRA payment stream in a manner favorable to Lone Star. Following the IPO, Lone Star held a majority of outstanding voting power and controlled a majority of the Company’s board.
By 2018, the expected value of TRA payments to Lone Star had decreased by almost one-third due to the reduced federal corporate income tax rate that was approved in 2017. This made the ETP more valuable and attractive, and Lone Star began exploring exit options early in 2018. The Lone Star–controlled board followed suit and approved a sale process for the Company. The Company retained legal and financial advisors with close ties to Lone Star. The interests of the financial advisor were further aligned with Lone Star by virtue of a success fee that included the value of an ETP as a percentage of consideration received in any deal.
Several months later, recognizing a potential conflict of interest, the Company formed a special committee comprising three directors unaffiliated with Lone Star. Although the special committee had broad authority over the sale process, including the right to “say no” and consider strategic alternatives, the court observed that the special committee met infrequently and largely deferred to Lone Star’s representatives who were managing sale negotiations despite the potential conflict of interest. And similar to the Company’s financial advisor, the special committee’s financial advisor linked its compensation to the value of any ETP received.
By mid-November 2020, following a stop-and-go sale process led primarily by representatives of Lone Star, both the special committee and the board approved a merger of the Company with a subsidiary of American Securities, LLC. The merger closed in January 2021. The merger consideration was $19.25 per share, plus a $74.8 million ETP to Lone Star and an $8.6 million payment to Lone Star under the TRA used through the date of closing. The Company’s and the special committee’s financial advisor each received a $1.5 million success fee.
Breach of Fiduciary Duty: Sale Process Claims
The plaintiff contended that Lone Star, its designated directors, the Company’s CEO, and the special committee breached their fiduciary duties by (1) opting for a sale rather than continuing to operate the Company, (2) diverting the merger consideration to Lone Star through the ETP, and (3) following an unreasonable sale process.
The court upheld the first claim, subjecting the transaction to the entire fairness standard due to the conflict of interest created by the ETP and the non-ratable benefit it provided to Lone Star. The court found that the plaintiff’s allegations supported a reasonably conceivable inference that the Lone Star defendants began pursuing a sale of the Company as a result of a reduced stream of expected contractual payments under the TRA and also supported a reasonably conceivable inference that the value-maximizing option for the Company and its minority stockholders was to continue to operate as an independent entity and pay lesser amounts to Lone Star under the TRA.
Conversely, the court dismissed the second claim, concluding that the ETP was a contractual right and thus not a diversion of consideration from minority stockholders. The third claim was also dismissed, as the court found the sale process reasonable “given Lone Star’s substantial economic alignment” with other stockholders to maximize value via a sale.
The special committee sought dismissal solely on the basis of exculpation under Section 102(b)(7) of the DGCL. Given the pleadings-stage posture and entire fairness standard of review, the court found it reasonably conceivable that the special committee consciously disregarded their fiduciary duties and deferred to the interests of Lone Star. Although the plaintiff stated a non-exculpated claim against the special committee members for bad faith, a subset of breaching the duty of loyalty, the court noted that exculpation remained a strong defense and could lead to judgment in the special committee’s favor at a later stage of the case.
The aiding and abetting claims against the financial advisors of both the board and the special committee were also upheld. The court found that each advisor was incentivized to favor transactions benefiting Lone Star given that their fees were contingent on a merger consideration that included an ETP.
Breach of Fiduciary Duty: Disclosure Claims
The court upheld the plaintiff’s inadequate disclosure claim focused on the lack of disclosure regarding the influence of the TRA on the decision to sell and the financial advisors’ fee structures and their relationship to Lone Star. The court criticized the Company’s descriptions for lacking “meaningful information” about the TRA’s and the ETP’s calculation and rationale. Additionally, the court found the proxy statement inadequate for failing to disclose that a portion of the advisors’ fees included consideration Lone Star would receive under the TRA and for omitting material information about the advisors’ relationships with Lone Star.
Takeaway
The Foundation Building Materials case is another reminder of Delaware interest in protecting minority stockholders in M&A deals where the transaction presents diverging interests among the minority stockholders and a controlling stockholder. Indeed, the surviving breach of fiduciary duty claim in Foundation Building Materials is premised on a perceived conflict of interest due to the non-ratable benefit to the controlling stockholder. Importantly, the court dismissed the two breach of fiduciary duty claims where the interests of the controller and the minority stockholders were aligned. From a governance perspective, the Foundation Building Materials decision underscores the significance of a well-functioning and properly authorized special committee in a conflicted transaction. The court’s decision is also a cautionary tale for the retention of independent advisors and ensuring that advisors’ compensation is aligned with the interests of the stockholders that the special committee is designed to protect.
* Nicole Pirone, a summer associate at McCarter & English not yet admitted to the bar, contributed to this alert.