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Court Applies Entire Fairness Test to Reverse Stock Split

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In evaluating a reverse stock split, the Court in Ginette Reis v. Hazelett Strip-Casting Corp., C.A. No. 3552-VCL (Del. Ch. Jan. 21, 2011) applied an entire fairness analysis and held that a board’s attempt to cash out minority shareholders via a reverse split was neither the subject of a fair process nor resulted in a fair price.


Hazelett Strip-Casting Corporation was formed by brothers, Bill and Dick Hazelett. The Company sells strip-casting machines, but the majority of its business is derived from servicing machines and parts sales. The brothers owned the Company, with Bill owning 800 shares (70%) and Dick 350 shares (30%). There were no voting agreements or supermajority voting requirements limiting Bill’s control as the majority shareholder. In 1994, Bill formed a limited partnership and contributed all of his shares to the limited partnership. The company’s board consisted of Bill (Chairman, President, and CEO), Bill’s son David, and three company employees. In 2002, Dick died. He bequeathed his 350 shares to 169 people who for the most part were past or then present company employees. Among the recipients were the executors for Dick’s estate.

Bill and David were not pleased that the family company was slated to be owned by an additional 169 people. Accordingly in October 2004, the company offered to purchase the shares for Dick’s estate at $1,500 per share. In unilaterally arriving at that price, Bill testified that he “just pulled [the price] out of the air.” David tried to rationalize the price to the Executors of Dick’s estate claiming that the price was: 1) more than double the per share amount provided for in an 1981 stock purchase agreement; 2) slightly more than that 1981 amount adjusted for inflation in 2004; and 3) nearly $600 more than when the shares were valued in a 2003 valuation the Estate had conducted. David also suggested that if the Estate denied the offer, the company may offer to purchase shares from some of the beneficiaries, but for no more than $990 per share. Bill eventually increased the offer to roughly $2,078.32 in 2005.

The Reverse Stock Split

Because the Estate had balked at the offer to purchase and was seemingly holding out for a higher offer, the board by unanimous written consent approved a reverse stock split. Under the split, each of the Estate’s outstanding shares became a 1/400 fractional interest – amounting to a total 350/400 of a share for the Estate. Bill’s limited partnership held two shares. The board resolved to arrange for a disposition of the fractional interest or pay in cash the fractional interest’s fair value. At a stockholder meeting where the only stockholder was Bill’s limited partnership, the reverse split was approved.

The board’s retained valuation firm valued each 1/400 interest at $1,595.17. The Executors refused to accept the cash offer for the Estate. The Probate Court, despite the Executors’ opposition, approved the distributions from the Estate. The matter was appealed and this action was also brought by one of the two Executors. The appeal was dismissed in favor of the Chancery action.

In 2008, the Court of Chancery held that the certificate amendment was effective as of January 28, 2008 – which would be the date used for valuation. The Court then denied a summary judgment motion where the defendants argued that their actions were protected by the business judgment rule and that the plaintiff was only entitled to a statutory claim for fair value under 8 Del. C. § 155(2). The Court denied the motion and held that the controller and conflicted directors had the burden to prove that the reverse split was entirely fair.

Section 155 and “Fair Value” Analysis

Under § 155, if a corporation issues fractional interests and seeks to compensate the shareholders instead of issuing fractional shares, “then the corporation must pay ‘in cash’ an amount equal to the ‘fair value’ of the fractional interests ‘as of the time when those entitled to receive such fractions are determined.’”

Unlike an appraisal under § 262, the corporation determines the fair value and the court’s role is to ensure that the board complied with § 155(2) and did not breach its fiduciary duties. In reviewing the board’s determination, the entire fairness analysis applies. A final stage transaction is a transaction that is “the last (or only) in a series” thereby giving rise to “the incentive to cheat . . . because . . . the penalty for doing so has disappeared.” This final stage transaction – the reverse split to freeze out the minority shareholders – was subject to the entire fairness test. The transaction must be entirely fair to the corporation and the shareholders and must be “the product of both fair dealing and fair price.”

Defendants’ Burden of Proof

Where, as here, a controlling stockholder employs “a reverse split to freeze out minority stockholders without any procedural protections, the transaction will be reviewed for entire fairness with the burden of proof on the defendant fiduciaries.” The burden will be shifted to the plaintiff to prove unfairness where the board appoints a special committee or if the split was contingent upon a majority-of-the-minority vote. If both mechanisms are used, the action can avoid an entire fairness review. Because all of the directors were beholden to Bill and because no protective devices were employed, the reverse split was subject to entire fairness with the burden of proof on the defendants.

The Applicable Valuation Standard

The Court noted that “the Delaware Supreme Court opined that ‘fair value’ in Section 155 [has] a meaning independent of the definition of ‘fair value’ in Section 262 of the [DGCL] … This holding creates an interpretive conundrum when a reverse split must be reviewed for entire fairness, because the ‘fair price’ aspect of the unitary entire fairness standard is widely regarded as requiring a valuation analysis equivalent to the “fair value” inquiry in an appraisal.” Fairness exists where “the minority stockholder shall receive the substantial equivalent in value of what he had before.” As in the § 262 context, the shareholder is entitled to the value of his shares as a going concern and the Court must consider “all relevant factors.” While the remedy in a § 155 case may be different from a § 262 case, the fair price analysis is the same.

The Entire Fairness Analysis

Where entire fairness applies, “the defendants must establish ‘to the court’s satisfaction that the transaction was the product of both fair dealing and fair price.’” The Court found that because the board did not employ any procedural protections and because the minority had no one to bargain on its behalf, there was no fair dealing. Bill and David’s heavy handed threats to the Estate concerning the potential consequences of turning down the offer further confirmed that there was no fair dealing. Such threats “by a controller are evidence of unfairness.”

The Court noted, “[h]aving failed to implement a fair process, the defendants did not serendipitously arrive at a fair price. Technically, the defendants did not set any price.” For trial, the defendants relied on a valuation as of September 30, 2005 based on which the Company paid $1,595.17 per fractional interest ($1,834,443 in the aggregate.) At trial, defendants introduced another opinion which held that the shares were worth $1,517.39 per fractional interest ($1,745,000 in the aggregate), which in the aggregate was approximately $90,000 less than the 2005 valuation. The plaintiff on the other hand issued a report that valued each fractional interest at $5,489 ($6,312,000 in the aggregate).

The Court held that the defendants’ 2005 price of $1,595.17 per fractional interest did not fall within the range of fairness. In this analysis, the Court will “ask[] whether the transaction was one ‘that a reasonable seller, under all of the circumstances, would regard as within a range of fair value; one that such a seller could reasonably accept.’” In this case, because “the defendants did not set out to extract value rapaciously from the minority” but were nonetheless disinterested, the only remedy would be a fair value award. Thus, the Court combined the fair price analysis and the remedial determination, utilizing the same inquiry as to price.

The Fair Value

The Court relied on two valuation methods, capitalized earnings and book value, while rejecting two of the plaintiff’s methods, comparable companies (because the companies used for comparison were not sufficiently similar) and capitalized free cash flow (because it largely mirrored the capitalized earnings method, but also required significant adjustments to provide a reliable going concern value).

Capitalized Earnings

The capitalized earnings method considers the Company’s earnings and a capitalization rate. The Court noted that where available, reliable earnings projections should be used and if they do not exist, historical earnings may be used (under the Delaware Block Method typically a five year period is used). The Court found problems with the defendants’ capitalized earnings method in that the defendants made some normalizing adjustments that were not consistent with Delaware law.

With respect to the capitalization rate, the Court noted that it “is often obtained ‘through a comparison with similar publicly traded companies whose market capitalization and earnings measures are publicly disclosed’” and a “‘price-to-earnings (‘P/E’) ratio derived from the P/E ratios of comparable companies is typically used.” In determining the capitalization rate, the Court found it necessary to deduct a growth factor, eventually arriving at an 12.6% capitalization rate. Adding in the value of non-operating assets and the amount paid in the reverse split, the Court arrived at a fractional interest of $3,175. In the aggregate, this amounted to $3,651,476.

Book Value

The Court also considered the company’s book value. While book value is an appropriate method for companies that derive significant value from their physical assets, such as Hazelett Strip Casting, it also tends to undervalue the business as a going concern. By the end of 2007, the company’s book value was $7.7 million.

Fair Value Award

The large gap between the aggregate capitalized earnings value and the book value reinforced the Court’s concern that the Company’s earnings had been depressed to benefit the owners. As a result, the Court considered a blended metric where capitalized earnings accounted for 80% and book value for 20%. The result was an aggregate value of $4,576,536 or $3,980 per fractional interest. Because the plaintiff and the non-defendant beneficiaries held 330 of the 350 shares bequeathed to the Estate, the Court entered an award of $1,313,267 with an offset for the $526,406.10 paid in the reverse split plus “(1) the interest actually earned on that amount while the funds were in escrow plus (ii) interest at the legal rate, compounded quarterly, from the date the amount was distributed to the beneficiaries through January 28, 2008.” That award was subject to pre- and post-judgment interest calculated at the legal rate and compounded quarterly.

SUPPLEMENT: Professor Stephen Bainbridge analyzes the Business Judgment Rule aspects of this case in a post available here.

This summary was prepared by Kevin F. Brady and Ryan P. Newell.

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