In re Sears Hometown and Outlet Stores, Inc. Stockholder Litigation
Del. Ch., C.A. No. 2019-0798-JTL (Jan. 24, 2024) (2024)
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Rule of Law:
When a controlling stockholder exercises stockholder-level voting power to prevent board action or remove directors, such actions are subject to enhanced scrutiny, requiring the controller to prove a good faith, legitimate objective and reasonable means. However, a subsequent self-dealing transaction must meet the entire fairness standard, and even permissible prior actions by the controller can taint the negotiation process, leading to a finding of unfair dealing and price.
Facts:
- In October 2012, Sears Holdings Corporation spun off Sears Hometown and Outlet Stores, Inc. (SHOS), and Edward S. Lampert, through the ESL Funds, became the controlling stockholder of SHOS.
- SHOS operated two business segments: Hometown, which generated increasing losses from 2014 to 2018, and Outlet, which, after years of losses, became profitable in 2018.
- In October 2018, Sears Holdings filed for Chapter 11 bankruptcy, causing SHOS management to believe the Hometown segment would likely need to liquidate due to its reliance on Holdings for inventory and services.
- The SHOS Board reactivated a Special Committee (comprised of Kevin Longino, David Robbins, and William K. Phelan) to evaluate strategic alternatives, including a Hometown liquidation plan or a transaction with Lampert.
- The Special Committee endorsed a plan to liquidate Hometown and operate Outlet as a standalone business, valuing it significantly higher than SHOS's market price, and set an April 15, 2019, deadline for Lampert to make a viable offer.
- Lampert, believing the Hometown liquidation plan was value-destructive and would incur substantial unacknowledged liabilities, offered to acquire SHOS for $2.25 per share, which the Special Committee rejected, reiterating its $9.50 per share ask.
- On April 15, 2019, Lampert, using his majority stockholder voting power, amended SHOS's bylaws to require supermajority board approval and two votes 30 days apart for a Hometown liquidation, effectively blocking the plan, and removed Special Committee members Phelan and Robbins from the Board.
- Following Lampert's intervention, the sole remaining Special Committee member, Kevin Longino, resumed negotiations with Lampert, leading to a transaction that involved Lampert acquiring SHOS for a base price of $2.25 per share plus a go-shop process for the Outlet segment.
Procedural Posture:
- Following the announcement of the transaction, two stockholder plaintiffs filed putative class actions challenging its terms, and a third stockholder sought books and records in the Court of Chancery of the State of Delaware.
- After the inspection was completed and the transaction closed, the stockholder claims were consolidated into a single lawsuit.
- Separately, another Company stockholder filed an appraisal action, and the court entered an order coordinating the plenary action and the appraisal action for purposes of discovery.
- During discovery, the plaintiffs dismissed their claims against SHOS directors William Powell, E.J. Bird, and James Gooch without prejudice.
- In January 2023, the plaintiffs agreed to settle their claims against SHOS directors Josephine Linden, Alberto Franco, and John Tober in exchange for a payment of $3.1 million to the class, which the court approved in November 2023.
- On December 12, 2022, the Company filed a voluntary petition for Chapter 11 bankruptcy, which brought the appraisal claim to a halt.
- The breach of fiduciary duty claims proceeded to a three-day post-trial hearing in the Court of Chancery of the State of Delaware against defendants Edward S. Lampert and his affiliates (ESL Investments, Inc., ESL Partners, LP, RBS Partners, LP, Transform Holdco LLC, and Hometown Midco LLC).
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Issue:
1. Does a controlling stockholder breach fiduciary duties by using its voting power to block a board-approved strategic plan that the controller believes is value-destructive, and by removing directors who advocated for that plan? 2. Is a subsequent self-dealing transaction, in which the controlling stockholder eliminates the minority's interests, entirely fair when the controller's prior actions effectively limited the company's strategic alternatives and altered the composition of the negotiating special committee?
Opinions:
Majority - Laster, V.C.
No, a controlling stockholder does not breach fiduciary duties by using its voting power to block a board-approved strategic plan (the Hometown liquidation) and removing directors (Phelan and Robbins) who advocated for that plan, provided the controller acts in good faith for a legitimate objective and employs reasonable means. The court found that when a controller exercises stockholder-level voting power, the standard of conduct requires that the controller not harm the corporation or minority stockholders intentionally or through grossly negligent action. This type of action is subject to enhanced scrutiny. Lampert credibly testified that he believed the Hometown liquidation would destroy value due to underestimated liabilities and overestimated proceeds, which was a legitimate objective formed after a reasonable investigation. His intervention was a reasonable response given the Special Committee's uncompromising stance and deadline. Therefore, Lampert did not breach his duties with the Controller Intervention. However, the subsequent self-dealing transaction in which Lampert acquired the company and eliminated the minority's interests was not entirely fair. This transaction triggered the entire fairness standard, with Lampert bearing the burden of proof for both fair dealing and fair price. On fair price, the court calculated the fair value of SHOS by combining the market-tested price for the Outlet segment (achieved through the go-shop) with a liquidation valuation for the Hometown segment and the value of net operating losses (NOLs). This analysis resulted in a fair value of $4.99 per share, significantly higher than the $3.21 per share the minority stockholders received, implying an exceptional control premium for Lampert (55.6%) and a substantial minority discount (36%). These figures were deemed indicative of an unfair price. On fair dealing, despite the Special Committee initially having an independent mandate and advisors, the Controller Intervention's fallout – specifically the removal of two of the three committee members and the effective elimination of the primary alternative (Hometown liquidation) – fatally undercut the committee's negotiating leverage. While the Outlet go-shop was well-structured, negotiations over the Hometown segment were 'desultory and incomplete,' and the overall process was deemed unfair. Thus, the transaction as a whole was not entirely fair.
Analysis:
This case significantly clarifies the standard of review applicable to a controlling stockholder's exercise of stockholder-level voting rights, distinguishing it from director-level actions. It establishes enhanced scrutiny for controller interventions that invade the board's traditional space, such as blocking strategic plans or removing directors, requiring the controller to prove a legitimate, good faith purpose and reasonable means. Critically, the decision illustrates that even if an initial controller action (like removing directors or amending bylaws) is deemed permissible under enhanced scrutiny, its practical impact on subsequent negotiations can still taint a later self-dealing transaction, leading to a finding of unfairness under the entire fairness standard. This nuanced approach emphasizes that 'fair dealing' can be undermined by the broader context of a controller's influence, even when individual acts are not breaches, impacting the ultimate fairness of a transaction and potentially leading to significant damages.
