IN THE COURT OF CHANCERY OF THE STATE OF DELAWARE

PATRICK DAUGHERTY,
Plaintiff,

V. C.A. No. 2019-0101-KSJM
JAMES DONDERO, THE VOTING
TRUST, THE SLHC TRUST, MARK
OKADA, THE MARK AND PAMELA
OKADA FAMILY TRUST-EXEMPT
DESCENDANTS TRUST, JOHN
HOLT, TED MAERIS, KENNETH
HANKS, and BRICE TARZWELL,

Nee ee eee eee Oe

Defendants.

ORDER GRANTING MOTION TO DISMISS

1. Plaintiff Patrick Daugherty owns common stock of non-party NexBank
Capital, Inc. (“NexBank”). On February 11, 2019, he filed this action against the
members of NexBank’s board of directors, including James Dondero and Mark
Okada. Directly and indirectly through trusts, Dondero owns over 65% and Okada
owns over 18% of NexBank’s outstanding common stock. Collectively, Dondero,
Okada, and their trusts own approximately 85% of NexBank’s outstanding common
stock. Daugherty alleges that Dondero, Okada, and their trusts comprise a control

group with concomitant fiduciary obligations to the minority stockholders of
NexBank.' For the purposes of the instant motion, Defendants do not dispute that
allegation, and thus this Order refers to Dondero, Okada, and their trusts collectively
as the “Controlling Stockholders.”?

2. Through his Verified Complaint (the “Complaint”), Daugherty takes
issue with 2016 and 2017 stock offerings (the “Stock Offerings”) that were offered
at an allegedly discounted price to participants. Daugherty couples his challenge to
the Stock Offerings with allegations concerning a loan program (the “Loan
Program”) that NexBank adopted in 2016 to provide directors and officers non-
recourse loans to cover pass-through tax liability for their NexBank shares.
Concerning the Loan Program, Daugherty alleges that during the year of the 2016
Stock Offering, NexBank’s balance of funded loans increased by $5,040,000, and in
the year of the 2017 Stock Offering, additional loans totaling $2,398,000 were
funded. The Loan Program was discontinued in 2017, and NexBank disclosed that
it was contemplating forgiveness of the balances of the loans as of December 31,
2016. Daugherty alleges, and it is reasonable to infer, that the purpose of the Loan

Program was to make the Stock Offerings more economically attractive to directors

 

' See C.A. No. 2019-0101-KSJM Docket (“Dkt.”) 1, Verified Compl. (“Compl.”) 4 5.

2 See Dkt. 26, Opening Br. in Supp. of Mot. to Dismiss P].’s Verified Compl. for Breach
of Fiduciary Duties (“Defs.’ Opening Br.”’) at 4, 7, 21, 30, 34, and 38.

2
and officers eligible to participate in the Loan Program, including Dondero and
Okada.

3. Conversely, the Stock Offerings were less economically attractive to
minority stockholders, like Daugherty, who were ineligible for the Loan Program.
Daugherty knew of the Stock Offerings and was eligible to participate on terms equal
to all other stockholders, but declined to participate due to the pass-through tax
liability additional stock ownership would impose, and because he was not eligible
to participate in the Loan Program. Because of the Stock Offerings, his voting and
economic interest in NexBank decreased from 1.66% to 1.31%, and the Controlling
Stockholders economic and voting interest in NexBank increased from 85.32% to
85.72%.

4. The Complaint asserts two Counts, each arising from the dilution of
Daugherty’s equity and voting interests. Count I claims that the Controlling
Stockholders breached their fiduciary duties as controllers. Count II claims that the
NexBank board members named as defendants breached their fiduciary duties as
directors. This Order refers to the two Counts collectively as the “dilution claims.”

5. The defendants have moved to dismiss the dilution claims pursuant to
Court of Chancery Rule 12(b)(6). On a motion to dismiss pursuant to Rule 12(b)(6),
the Court accepts “all well-pleaded factual allegations in the Complaint as true, [and]

accept[s] even vague allegations in the Complaint as ‘well-pleaded’ if they provide
the defendant notice of the claim.”* “A trial court is not, however, required to accept
as true conclusory allegations ‘without specific supporting factual allegations.’
The Court “draw[s] all reasonable inferences in favor of the plaintiff, and den[ies]
the motion unless the plaintiff could not recover under any reasonably conceivable
set of circumstances susceptible of proof.”

6. The defendants assert multiple arguments in support of dismissal, but
only one is pertinent to the disposition of this case. The defendants contend that the
dilution claims are derivative in nature and should fail because Daugherty makes no
effort to satisfy the demand futility requirements for pleading a derivative claim.
Daugherty asserts that the dilution claims can be brought directly within the
transactional paradigm under Gentile v. Rossette,° but he has not argued in the
alternative that demand would be futile if the Court finds that his claims are, in fact,
derivative in nature.

7. In Gentile, the Delaware Supreme Court recognized “a species of

corporate overpayment claim” that a stockholder can assert both derivatively and

directly:

 

3 Cent. Mortg. Co. v. Morgan Stanley Mortg. Capital Hldgs. LLC, 27 A.3d 531, 536 (Del.
2011) (citing Savor, Inc. v. FMR Corp., 812 A.2d 894, 896-97 (Del. 2002)).

4 In re Gen. Motors (Hughes) S’holder Litig., 897 A.2d 162, 168 (Del. 2006) (quoting Jn
re Santa Fe Pac. Corp. S’holder Litig., 669 A.2d 59, 65-66 (Del. 1995)).

> Cent. Mortg., 27 A.3d at 536 (citing Savor, 812 A.2d at 897).
6 906 A.2d 91 (Del. 2006).
A breach of fiduciary duty claim having this dual character
arises where: (1) a stockholder having majority or
effective control causes the corporation to issue
“excessive” shares of its stock in exchange for assets of
the controlling stockholder that have a lesser value; and
(2) the exchange causes an increase in the percentage of
the outstanding shares owned by the controlling
stockholder, and a corresponding decrease in the share
percentage owned by the public (minority) shareholders.
Because the means used to achieve that result is an
Overpayment (or “over-issuance”) of shares to the
controlling stockholder, the corporation is harmed and has
a claim to compel the restoration of the value of the
overpayment. That claim, by definition, is derivative.

But, the public (or minority) stockholders also have a
separate, and direct, claim arising out of the same
transaction. | Because the shares representing the
“overpayment” embody both economic value and voting
power, the end result of this type of transaction is an
improper transfer—or expropriation—of economic value
and voting power from the public shareholders to the
majority or controlling stockholder. For that reason, the
harm resulting from the overpayment is not confined to an
equal dilution of the economic value and voting power of
each of the corporation’s outstanding shares. A separate
harm also results: an extraction from the public
shareholder, and a redistribution to the controlling
shareholder, of a portion of the economic value and voting
power embodies in the minority interest. As a
consequence, the public shareholders are harmed,
uniquely and individually, to the same extent that the
controlling shareholder is (correspondingly) benefited.’

8. Put differently, “the harm Gentile seeks to remedy arises ‘when a

controlling stockholder, with sufficient power to manipulate the corporate processes,

 

7 Td. at 99-100.
engineers a dilutive transaction whereby that stockholder receives an exclusive
benefit of increased equity ownership and voting power for inadequate
consideration.””®

9. The Delaware Supreme Court narrowly construed the Gentile doctrine
in El Paso Pipeline GP Co. v. Brinckerhoff? In that case, a limited partner
challenged alleged overpayments to a controller that reduced the limited partners’
economic interests but not their voting rights.'° The Court distinguished the facts of
Gentile, where the challenged transactions “resulted in an improper transfer of both
economic and voting power from the minority stockholders to the controlling
stockholder,”'! and declined to apply Gentile on this basis. In a concurring opinion,
the Chief Justice urged his colleagues to overrule Gentile.'* Consequently, “[i]n the
wake of E/ Paso, [the Court of Chancery] has exercised caution in applying the
Gentile framework, commenting in one case that ‘[w]hether Gentile is still good law

is debatable’ and finding in another that ‘Gentile must be limited to its facts.’”"

 

8 Klein v. H.LG. Capital, L.L.C., 2018 WL 6719717, at *6 (Del. Ch. Dec. 19, 2018)
(quoting Feldman v. Cutaia, 956 A.2d 644, 657 (Del. Ch. 2007), aff'd, 951 A.2d 727
(Del. 2008)).

9 152 A.3d 1248 (Del. 2016).

10 7d. at 1264.

'! Td. at 1263 (emphasis in original).

12 Td. at 1266 (Strine, C.J., concurring).

'3 Klein, 2018 WL 6719717, at *7 (first quoting ACP Master, Ltd. v. Sprint Corp., 2017
WL 3421142, at *26 n.206 (Del. Ch. July 21, 2017), aff'd, 2018 WL 1905256 (Del.

6
10. Applying this framework, the Complaint fails to state a claim under
Gentile as to the 2016 Stock Offering. For a dilution claim to meet the narrow
criteria of Gentile, a controller must extract a benefit from the challenged
transaction. “As such, a transaction does not fit within the Gentile paradigm if the

”14 Accepting the allegations in the

controller itself is diluted by the transaction.
Complaint as true, the Controlling Stockholders’ positions decreased as a result of
the 2016 Stock Offering from 85.32% to 84.94%. It was only after the 2017 Stock
Offering that the Controlling Stockholders’ net equity and voting positions
increased. Any challenge to the 2016 Stock Offering thus fails because the
Controlling Stockholders were diluted in the transaction.

11. The Complaint also fails to state a claim under Gentile as to the 2017
Stock Offering, even though it resulted in a marginal increase to the Controlling

Stockholders’ net equity and voting positions. This is so because Gentile and its

progeny require that the expropriated benefit inure exclusively to the controllers.’

 

Apr. 23, 2018); then quoting Almond for Almond Family 2001 Tr. v. Glenhill Advisors
LLC, 2018 WL 3954733, at *24 (Del. Ch. Aug. 17, 2018)).

'4 Glenhill, 2018 WL 3954733, at *28 (citing Dubroff v. Wren Hldgs., 2011 WL 5137175,
at *9 (Del. Ch. Oct. 28, 2011)); see also Dubroff, 2011 WL 5137175, at *9 (“[M]inority
shareholders may have a direct equity dilution claim when their holdings are diluted, and
those of the corporation’s controller are not.”).

'S Gentile, 906 A.2d at 94-95 (involving a transaction where controller was sole recipient
of extracted benefit); Feldman, 956 A.2d at 657 (articulating the Gentile standard as
requiring controller to receive an “exclusive benefit of increased equity ownership and
voting power for inadequate consideration” (emphasis added)); Klein, 2018 WL 6719717,
at *6 (quoting “exclusive benefit” language of Feldman); Glenhill Advisors, 2018

7
Cases interpreting this exclusivity requirement have found it lacking where all
stockholders are equally eligible to participate in the challenged transaction.'® In
this case, Daugherty concedes that he and all other minority stockholders had the
opportunity to participate in the Stock Offerings. Accordingly, Gentile does not
apply.!”

12. The side-benefit of the Loan Program does not change this analysis.
Daugherty argues that the Loan Program commenced in tandem with the Stock
Offerings as part of a greater scheme to benefit the Controlling Stockholders. But
the benefits of the Loan Program were extended to all NexBank directors and
officers, not just the Controlling Stockholders. And as discussed, the Loan Program
actually served to dilute the Controlling Stockholders in 2016. Thus, the Loan
Program does not extend an exclusive benefit to the Controlling Stockholders in

isolation or conjunction with the Stock Offerings.

 

WL 3954733, at *28 (same); Sciabacucchi v. Liberty Broadband Corp., 2018 WL
3599997, at *7 (Del. Ch. July 26, 2018) (same).

16 See, e.g., Feldman, 956 A.2d at 658 (noting that plaintiff does not allege “that he, or any
other person who was a [minority] stockholder at the time, was barred from participating”);
Sheldon v. Pinto Tech. Ventures, L.P., 2019 WL 336985, at *9 (Del. Ch. Jan. 25, 2019)
(noting that the alleged controllers “were not the only participants in the [challenged
financing rounds]”); Bomberger v. Benchmark Builders, Inc., 2016 WL 4411527, at *3
(Del. Ch. Aug. 19, 2016) (noting that plaintiffs complaint conceded that plaintiff “was
given the opportunity to participate in [the company’s] subsequent equity offerings”).

'7 This reasoning also provides an alternative basis for dismissing claims challenging the
2016 Stock Offering.
13. Inthe end, Daugherty’s dilution claims challenging the Stock Offerings
are classic derivative overpayment claims. Because Daugherty does not attempt to
meet the requirements for pleading a derivative claim, the dilution claims are
dismissed.

14. For the foregoing reasons, Defendants’ motion to dismiss the

Complaint is GRANTED with prejudice.

Last Dan Se} Mp2 _

Vice Chancellor KatKaleen St. J. McCormick
Dated: September 27, 2019
