Delaware Court Expands Shareholders’ Right to Sue for Diluted Merger Proceeds

Delaware Court Expands Shareholders’ Right to Sue for Diluted Merger Proceeds

By Sarah Pierce

A recent Delaware Chancery Court decision could prove to be a major boon for Silicon Valley entrepreneurs and early dot com hires who want to challenge mergers that cut them out of the proceeds while richly rewarding company insiders.

On March 15, the court ruled in Carsanaro v. Bloodhound Technologies Inc. that shareholders could sue directly for the loss in value they suffered from their diluted interest, opening the door for class action lawsuits and strengthening their legal standing. Previously, many of these “direct” claims were classified as “derivative” claims. Under Delaware law, cash-out mergers eliminate the right of shareholders to sue a corporate entity because only current stockholders may assert a derivative claim.

The distinction between direct and derivative is an important one for startup founders and early employees – like the plaintiffs in this case – who want to challenge merger transactions that dilute their proceeds from the sale of their companies.

In Carsanaro v. Bloodhound, plaintiffs Joseph A. Carsanaro – the founder of Bloodhound Technologies – and the company’s four original employees accuse venture capitalists of orchestrating a coup that removed Carsanaro and allowed them to obtain control of the company’s board of directors. From that point on, they say, the VCs raised new funding on terms that favored them and reverse-split the common stock. In the end, the total ownership interest of all common stockholders had been diluted to just over 2%. The founder and other plaintiffs found they held less than 1%, allowing them to cash out less than $36,000 from the $82.5 million that was given to the controllers.

The plaintiffs sued the members of the board who approved the transactions and their affiliated funds and challenged the diluted shares, the allocation of the merger proceeds to management, and the fairness of the merger.

The defendants sought to dismiss the complaint on several grounds, including that stock dilution was a derivative claim, not a direct one, and therefore the plaintiffs lacked standing.

The Delaware Court of Chancery, however, ruled the plaintiffs had the right to sue directly for the loss in value they suffered by the dilution and the merger “because each financing challenged in the complaint was a self-interested transaction implicating the duty of loyalty and raising an inference of expropriation,” according to the order.

The Bloodhound ruling significantly expands the rights of stockholders to challenge the terms of a merger they say unfairly benefits management. While the impact of the ruling will play out in later cases, it is likely to open the door to class action lawsuits from shareholders alleging company insiders unfairly cut them out of what belongs to them.

A copy of the court’s detailed analysis can be found here.

The case is Carsanaro v. Bloodhound Technologies Inc., Case No. 7301-VCL, Delaware Court of Chancery.

Updated April 5th, 2013

All class action and lawsuit news updates are listed in the Lawsuit News section of Top Class Actions