In In re EZCorp Inc. Consulting Agreement Derivative Litigation, 2016 WL 301245 (Del. Ch. Jan. 25, 2016), the Court of Chancery denied a motion to dismiss derivative claims challenging a series of payments between a corporation and its controlling stockholder, even though those payments had been approved by the Audit Committee of the corporation’s board. After review of extensive case law, the Court concluded that the weight of authority called for application of the entire fairness standard at the pleading stage, with the possibility that an evidentiary showing of independent committee approval could support a shift in the burden of proof later in the case. The Court determined that such transactions could be subject to dismissal at the pleading stage under the business judgment rule only where the transaction is approved by both an independent committee of the board and a majority of the minority stockholders.
Headquartered in Austin, Texas, EZCORP Inc. (“EZCORP” or the “Company”) provided instant cash solutions through a variety of products and services, including pawn loans, other short-term consumer loans, and purchases of customer merchandise. The plaintiff stockholder brought suit challenging the fairness of three advisory service agreements between the Company and defendant Madison Park, LLC, an affiliate of the Company’s controlling stockholder, Phillip Cohen. Cohen was the sole stockholder of the general partner of the limited partnership that held all of the Company’s voting common stock. Thus, Cohen held 100% of EZCORP’s voting power, but only 5.5% of its equity.
In May 2014, the Audit Committee terminated the renewal of one of the service agreements, allegedly due in part to the committee’s concern about the fairness of the relationship between the Company and Madison Park. In early July, the stockholder-plaintiff made a demand under Section 220 of the Delaware General Corporation Law to inspect the Company’s books and records relating to the service agreements. Nine days after the books and records demand arrived, Cohen responded to the termination by removing three directors (including two members of the Audit Committee that had terminated the agreements and the Company’s CEO) from the board; another director resigned the same day.
The Court considered at length the appropriate standard of review for transactions in which a corporation’s controlling stockholder receives a non-ratable benefit. The Court noted that, in an ordinary case involving self-dealing between a corporation and its controlling stockholder, the standard of review is entire fairness and the burden of proof rests on the defendants. However, in the context of a cash-out merger, the Delaware Supreme Court has held that application of the business judgment rule is appropriate if, but only if, the transaction is conditioned ab initio on both the affirmative recommendation of a sufficiently authorized, independent and disinterested committee of the board and the affirmative vote of a majority of the minority stockholders. See Kahn v. M & F Worldwide, 88 A.3d 635 (Del. 2014). If the controlling holder agrees to use only one of these protections, however, “then the most that the controller can achieve is a shift in the burden of proof such that the plaintiff challenging the transaction must prove unfairness.”
The Court then considered a controversy posed in the case law: whether challenges to controlling-stockholder transactions other than cash-out mergers may be dismissed under the business judgment rule where the transaction is conditioned on either approval by an independent and disinterested board committee or approval by a majority of the minority stockholders, but not both. After an extensive review of cases taking both sides of that issue, the Court concluded that the weight of the authority called for a broader application of the entire fairness framework.
The Court also considered the tension between that conclusion and the demand futility analysis articulated in Aronson v. Lewis, 473 A.2d 805 (Del. 1984), a case in which the Delaware Supreme Court had reversed (on discretionary interlocutory review) the Court of Chancery’s denial of a motion to dismiss a derivative suit challenging a transaction with a 47% stockholder that had been approved by a majority disinterested and independent board, but not by the corporation’s stockholders. The Supreme Court in Aronson held that, unless a stockholder plaintiff pleads particularized facts calling into question the board’s ability to exercise properly its independent and disinterested business judgment in responding to a demand to institute suit, a board’s refusal to sue is subject to business judgment review. After extended discussion of post-Aronson case law, the Court determined that Aronson applies only to the demand-excusal context and does not provide an independent basis for changing the substantive standard of review of controlling stockholder transactions.
After finding that the operative standard of review was entire fairness with possible burden shifting based on the Audit Committee’s approval of the service agreements, the Court held that the complaint supported a reasonable inference that the agreements were not entirely fair. Among the factors that the Court found to raise such inference were: (i) Cohen’s voting control despite having only a 5.5% equity stake; (ii) the long history of advisory service agreements between the Company and Cohen’s affiliates; (iii) the amount and timing of the payments; (iv) the minimal resources of Madison Park; (v) the duplication between the services Madison Park provided and the capabilities of the Company management; (vi) the lack of similar service agreements at any of EZCORP’s peer companies; (vii) the decision by two members of the Audit Committee to cancel the renewal of one agreement; and (viii) Cohen’s retaliation against those board members.
The Court added that at the motion to dismiss stage, the involvement of the Audit Committee in the transactions does not defeat the fiduciary duty claim because a determination of whether an independent committee is “well-functioning” requires a “fact intensive inquiry.”
The Court next turned to its analysis under Court of Chancery Rule 23.1. The Court found that reasonable doubt existed as to the ability of a majority of the directors to exercise independent and disinterested business judgment over a demand, and thus that demand was excused. Notably, the Court found demand excused as to a retired board member whom Cohen brought out of retirement and reappointed after removing three directors in July 2014. While the Court acknowledged the general rule that a director’s nomination or election by an interested party is, by itself, insufficient to raise a reasonable doubt about his independence, “it is not necessarily irrelevant.” The Court found that this director’s alleged “eagerness to be of use,” combined with his participation as an Audit Committee member in approving some of the challenged agreements, could support the reasonable inference that “Cohen wanted to bring back a cooperative member of the placid antebellum regime.”