Klang v. Smith's Food & Drug Centers, Inc.
1997 WL 697190, 702 A.2d 150 (1997)
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Rule of Law:
A corporate board of directors may determine the existence of a capital surplus for a stock repurchase by revaluing corporate assets and liabilities in good faith, based on acceptable data and reasonable methods reflecting present values; a balance sheet showing a deficit is not conclusive evidence of capital impairment.
Facts:
- Smith’s Food & Drug Centers, Inc. ('SFD'), a Delaware corporation, was controlled by Jeffrey P. Smith and his family, who held 62.1% of the voting power.
- On January 29, 1996, SFD entered into a complex agreement with The Yucaipa Companies ('Yucaipa').
- The agreement involved a merger between a Yucaipa subsidiary and an SFD subsidiary, with SFD issuing new stock to Yucaipa.
- As part of the deal, SFD planned a recapitalization, which included taking on significant new debt and offering to repurchase up to 50% of its outstanding public shares for $36 per share (a self-tender offer).
- The plan also included SFD repurchasing 3 million preferred stock shares from the Smith family.
- SFD engaged an investment firm, Houlihan Lokey Howard & Zukin ('Houlihan'), to provide a solvency opinion on the transactions.
- Houlihan's report concluded that the transactions would not impair SFD's capital under Delaware law.
- Relying on the Houlihan opinion, SFD's board determined on May 17, 1996, that sufficient surplus existed, and on May 23, 1996, stockholders approved the transactions.
Procedural Posture:
- Larry F. Klang filed a purported class action lawsuit in the Delaware Court of Chancery against SFD's directors and other affiliated parties.
- The complaint alleged that the stock repurchases violated 8 Del.C. § 160 by impairing SFD's capital and that the directors breached their fiduciary duty of candor.
- Plaintiff Klang moved the trial court to rescind the transactions.
- After full discovery, the Court of Chancery issued a Memorandum Opinion dismissing all of Klang's claims in their entirety.
- Plaintiff Klang, as appellant, appealed the dismissal to the Supreme Court of Delaware.
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Issue:
Does a corporation's repurchase of its own shares, which results in a negative net worth on its formal balance sheet, violate the statutory prohibition against capital impairment when the board of directors relies in good faith on an expert's revaluation of corporate assets to determine that a surplus exists?
Opinions:
Majority - Chief Justice Veasey
No, the corporation's repurchase does not violate the statutory prohibition against capital impairment. Directors are not bound by the balance sheet's statement of net worth and have reasonable latitude to revalue assets and liabilities to ascertain a surplus, so long as they do so in good faith using acceptable data and reasonable methods. The court's role is not to second-guess the board's valuation, but to determine if the board's process was conducted in good faith and without fraud. Here, the SFD board properly relied on Houlihan's expert opinion, which used a valid, albeit not explicitly statutory, methodology to conclude a surplus existed. The valuation was net of current liabilities, making it a reliable indicator of net assets. A clerical error in a board resolution documenting the surplus does not invalidate an otherwise lawful transaction.
Analysis:
This decision solidifies the principle that corporate balance sheets are not the definitive measure of capital surplus under Delaware's capital impairment statute. It grants boards significant deference and flexibility, allowing them to rely on modern, market-based valuation methodologies and expert opinions to justify transactions like stock repurchases. This ruling protects boards acting in good faith under the business judgment rule and enables corporations to engage in complex financial restructuring that might appear to impair capital based on traditional accounting but are economically sound. It places the burden on plaintiffs to show bad faith or fraudulent valuation, a high standard to meet.
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