Robert Garfield v. Blackrock Mortgage Ventures, LLC

Citation: Not availableDocket: C.A. No. 2018-0917-KSJM

Court: Court of Chancery of Delaware; December 19, 2019; Delaware; State Appellate Court

Original Court Document: View Document

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The legal action in question involves Robert Garfield, the plaintiff, challenging the fairness of PennyMac Financial Services, Inc.'s reorganization from an 'Up-C' structure to a standard corporate form. This reorganization allegedly favored defendants who held interests in the company's operating subsidiary while disadvantaging stockholders, particularly those like Garfield who hold Class A common stock. Garfield argues that the reorganization should be evaluated under the entire fairness standard due to the personal benefits received by certain defendants. The defendants sought dismissal based on the business judgment rule, asserting that a majority of disinterested stockholders approved the transaction, thereby invoking the protections of Corwin under Delaware law. However, the court determined that Corwin does not apply when a controller stands to benefit personally from the transaction, particularly because the complaint suggests that two significant stockholders constituted a control group benefiting from the reorganization. Consequently, the court found that the complaint adequately states a claim under the entire fairness standard. 

The factual background outlines that BlackRock, Inc. and HC Partners established PennyMac during the 2008 financial crisis to capitalize on acquiring distressed loans from financial institutions. They formed PennyMac, LLC, branding themselves as strategic partners to enhance PennyMac's relationships with global financial institutions and improve its investment management strategies.

BlackRock and HC Partners entered into the PennyMac LLC Agreement, granting them rights such as veto power over certain actions and the ability to convene official meetings. In 2009, PennyMac, LLC established PennyMac Mortgage Investment Trust (the Public REIT), which was externally managed by its subsidiary, PNMAC Capital Management, LLC. During its initial public offering, the Public REIT allocated 93.5% of its shares to public investors and 6.5% to BlackRock, HC Partners, and management, identifying the latter as 'strategic partners.'

In 2013, BlackRock, HC Partners, and former CEO Stanford L. Kurland executed an 'Up-C' transaction, leading to the formation of PennyMac, Inc., which became the parent company of PennyMac, LLC. PennyMac, Inc. issued Class A common stock to public investors, granting them 15% of the voting rights and 100% of the economic rights, while Class B shares were distributed to LLC Unitholders, who retained 85% of the voting rights and economic benefits through the LLC.

Two agreements were created alongside the 2013 Up-C transaction to leverage the tax-efficient Up-C structure. The Exchange Agreement permitted LLC Unitholders to exchange their LLC Units for Class A common stock on a one-for-one basis, potentially creating tax liabilities for them but offering tax benefits to PennyMac, Inc. The Tax Receivable Agreement entitled the Unitholders to 85% of any tax benefits PennyMac, Inc. realized, leaving 15% for the corporation itself. Both BlackRock and HC Partners co-signed this agreement.

Despite the Up-C structure's intention to facilitate tax benefits for LLC Unitholders, these benefits were undermined by the Tax Cuts and Jobs Act of 2017, which lowered the corporate tax rate from 35% to 21%, diminishing the value of PennyMac, LLC's tax assets. Additionally, significant growth in loan production and the ability to defer revenue from mortgage servicing rights led to current tax losses, prompting management to predict no taxable income for at least a decade, thereby nullifying the expected tax benefits.

Management proposed a reorganization of the Company, allowing LLC Unitholders to exchange their LLC Units for PennyMac, Inc. Class A common stock in a tax-free exchange, with long-term capital gains treatment for future sales if held over a year. Approval required a majority vote from stockholders, with Class A holders controlling 15% of voting rights and Class B holders controlling 85%. At the time, there were 25.2 million Class A shares and 52.3 million Class B shares, totaling 77.5 million votes. Kurland, the proponent, controlled 10.7% of the votes, while BlackRock and HC Partners controlled 20.1% and 26%, respectively. Kurland needed only their support for approval.

The Board, consisting of eleven members, recommended a vote in favor of the Reorganization. Seven of these directors, named as defendants, held more LLC Units than Class A shares. Notably, BlackRock and HC Partners had appointed directors involved in the process, including Kurland and other PennyMac officers. 

On April 24, 2018, management presented the Reorganization to BlackRock and HC Partners, highlighting tax savings of approximately $3.21 per Unit based on certain tax assumptions. A week later, a conference call took place to further discuss the proposal. During a Board meeting on May 30, 2018, Kurland indicated that BlackRock and HC Partners were likely to support the proposal. Following a presentation by management, the Board formed a Special Committee to evaluate the Reorganization, composed of Hunt, Kinsella, Tozer, and Youssouf.

The Special Committee, tasked with evaluating a Potential Transaction, was limited to making recommendations to the Board of Directors rather than granting final approval. On June 2, 2018, the Committee held a conference call with management and its legal advisor, Goodwin Procter, during which a member suggested the retention of independent counsel, but this did not occur. On June 11, management presented an analysis indicating a decrease in PennyMac, Inc.’s book value from $20.61 to $19.65 per share due to the Reorganization. The Committee discussed the implications of this decline in a subsequent call. They also considered issuing a special dividend (Distribution) to Class A common stockholders.

On June 29, the Committee reviewed excess cash accumulated since the IPO in 2013, discussing two distribution alternatives: the proposed Distribution or adjusting the share exchange ratio for the Reorganization. On July 13, the Committee favored the Distribution. On July 18, they recommended the Reorganization to the Board, which included a $10.1 million Distribution to Class A common stockholders, equating to $0.40 per share. The Board approved the Reorganization on July 24 and instructed officers to secure agreements from LLC Unitholders.

Negotiations between HC Partners and BlackRock led to a revision requiring their consent to terminate the Reorganization. The Board approved the revised agreement on August 2, 2018, noting that the Reorganization did not require majority-of-the-minority approval. Approval could occur with sufficient votes from Class B common stockholders. The Board announced the Distribution on August 2, and it was issued around August 30. The Reorganization was publicly announced the same day, with the Proxy issued on September 18. Stockholders approved the Reorganization on October 24, 2018, and it closed on November 1, 2018.

The Amended Complaint asserts that the stockholder vote was uninformed due to two categories of disclosure deficiencies: projections of PennyMac’s future profitability and the quantification of tax benefits for LLC Unitholders. 

1. **Projections**: The Proxy disclosures regarding future profitability projections are deemed incomplete. A June 15 conference call between the Special Committee and BlackRock revealed that management forecasts indicated PennyMac, Inc. would not generate taxable income in the near term, leading to a conclusion that the net present value of potential benefits to Class A Common Stockholders from future exchanges of PennyMac, LLC Units would likely be minimal. The Plaintiff argues that critical facts regarding these projections were not disclosed, including:
   - A June 12, 2018, Special Committee meeting where it was confirmed that no earnings forecasts would be provided, despite discussions on their relevance to Class A stockholders.
   - A presentation of base-case projections reviewed by BlackRock and the Board on April 24 and May 30, 2018, respectively.
   - Additional scenarios requested by BlackRock, which included detailed ten-year projections of revenue, expenses, and taxable income, were not disclosed.

2. **Tax Benefits**: The Proxy failed to disclose management’s analysis of potential tax savings for LLC Unitholders due to the Reorganization. Management indicated LLC Unitholders could save up to $3.21 per Unit with long-term capital gains treatment, contrasting with the ordinary income treatment under the Up-C structure. The Plaintiff highlights a chart showing that Class A common stockholders would forfeit 15% of the tax benefits under the Tax Receivable Agreement, while LLC Unitholders would forfeit 85%. Both groups would gain a simplified corporate structure, enhancing the attractiveness of PennyMac, Inc. stock, but only LLC Unitholders would benefit from long-term capital gains treatment on stock sales.

Plaintiff Robert Garfield asserts beneficial ownership of PennyMac, Inc. Class A common stock since December 10, 2015, and filed a Verified Class Action and Derivative Complaint on December 20, 2018, alleging two causes of action: a direct breach of fiduciary duty against Defendants and, alternatively, a derivative claim for the same breaches. Following Defendants' initial motion to dismiss, Plaintiff filed an Amended Complaint on March 11, 2019. Defendants renewed their dismissal motion on March 25, 2019, which was fully briefed by May 6, 2019, with oral arguments heard on September 10, 2019.

Defendants sought dismissal under Court of Chancery Rule 12(b)(6), which allows dismissal for failure to state a claim if the complaint lacks sufficient factual allegations to support relief. Delaware's pleading standard requires a "reasonable conceivability" of recovery. The Court must accept all well-pleaded allegations as true and draw reasonable inferences in favor of the plaintiff, denying dismissal unless recovery is impossible under any conceivable circumstances. However, conclusory allegations without specific facts are not accepted, nor are unreasonable inferences drawn for the non-moving party.

Defendants argue that the business judgment standard applies due to a majority vote of disinterested stockholders approving the Reorganization, claiming the Amended Complaint does not state a claim under this standard. They further assert that even if the entire fairness standard applies, Plaintiff has not shown the Reorganization was unfair. Plaintiff contends that Corwin is inapplicable as a controlling stockholder group exists whose interests diverged from those of other shareholders, and that the Amended Complaint adequately states a claim under the entire fairness standard.

A stockholder vote cannot restore the business judgment rule under Corwin if a controlling stockholder extracts personal benefits from a transaction, as this presence can coerce corporate decision-making. To benefit from the business judgment standard in controller transactions, procedural safeguards akin to arm's length negotiations must be in place, as outlined in MFW. Since these safeguards were absent in the Reorganization, the business judgment standard does not apply at the pleading stage if Plaintiff has adequately alleged a conflicted controller or control group. Plaintiff identifies BlackRock and HC Partners as such a control group, requiring the Amended Complaint to contain facts supporting a reasonable inference that they exercised sufficient control to establish fiduciary obligations under Delaware law.

BlackRock and HC Partners collectively control about 46.1% of PennyMac Inc.’s voting stock and possess the unilateral right to block the Reorganization under the LLC Agreement. Consequently, Kurland required their approval to proceed with the Reorganization. Each entity can appoint two representatives to the Board, totaling four out of eleven members. This situation raises the possibility that they could exert transaction-specific control if they collaborated.

The analysis hinges on whether BlackRock and HC Partners can be classified as a group at the pleading stage. The Delaware Supreme Court's decision in Sheldon v. Pinto established a 'legally significant connection' standard, requiring evidence of a connection among stockholders—such as agreements, common ownership, or other arrangements—that indicates collective control beyond mere self-interest. The Supreme Court referenced In re Hansen Medical Shareholders Litigation, where plaintiffs successfully demonstrated a control group through historical and transaction-specific ties, including a lengthy history of investment together, designation as a group in SEC filings, exclusive participation rights in private placements, and formal voting agreements.

To satisfy the Sheldon criteria, the Plaintiff argues that BlackRock and HC Partners are aligned in their interests regarding the exchange ratio favoring LLC Unitholders, following the precedent set in Hansen.

Plaintiff alleges significant ties between BlackRock and HC Partners, highlighting a decade of co-investment in PennyMac, where both entities acted as founding sponsors. The LLC Agreement and various IPO documents consistently refer to them as "Sponsor Members" and "strategic partners." This historical relationship indicates a long-standing collaboration. 

In terms of transaction-specific ties, Plaintiff claims that management engaged with BlackRock and HC Partners collectively during negotiations for the Reorganization, prioritizing their input over that of the Board and other LLC Unitholders. Management's approach depicted them as a unified entity and allowed them to influence the process significantly, including securing a provision that required their joint consent to terminate the Reorganization.

Defendants counter that BlackRock and HC Partners' interests were not aligned due to differing tax structures, with HC Partners benefiting from individual taxation and BlackRock from corporate taxation. However, the Court finds that, at the pleading stage, reasonable inferences must be drawn in favor of the Plaintiff, suggesting a legally significant connection between the two entities despite the tax discrepancies, as both sought to maximize their stake in the combined entity.

A reasonable inference of a control group exists based on historical and transaction-specific ties alleged by the Plaintiff, despite Defendants' argument that no written agreement between BlackRock and HC Partners grants them rights concerning the Reorganization. Defendants reference the case van der Fluit, where the court dismissed a similar theory due to agreements signed by unrelated stockholders and a lack of relevant provisions. While the written agreements in this case share some weaknesses noted in van der Fluit, their absence does not undermine the Plaintiff's theory; informal or unwritten agreements may still support the inference that BlackRock and HC Partners collaborated during the Reorganization. The determination of a control group requires a fact-intensive analysis, particularly challenging at the motion to dismiss stage. The facts presented make it reasonably conceivable that BlackRock and HC Partners constituted a control group exerting effective control over PennyMac, leading the Court to apply the entire fairness standard instead of Corwin at the pleading stage.

Defendants contend that the Plaintiff has not adequately questioned the Reorganization's fairness, which encompasses two aspects: fair dealing and fair price, though they are not strictly separate. The Plaintiff also argues that Corwin is inapplicable due to material omissions in the Proxy and Board conflicts, although this latter point conflicts with established court decisions. The Court does not need to resolve these alternative arguments since the control group allegations are sufficient to bypass Corwin's application at this stage.

The document emphasizes the necessity of evaluating all elements of a case to determine "entire fairness." At the pleadings stage, the potential application of the entire fairness standard makes it difficult for the Court to grant a motion to dismiss under Rule 12(b)(6). Fair dealing involves assessing the timing, initiation, structure, negotiation, disclosure to directors, and the approvals obtained from directors and stockholders. In cases with a special committee, the independence, knowledge, and negotiating power of that committee are critical. Fair price pertains to the economic factors influencing a merger, including assets, market value, earnings, and future prospects.

The Court has inferred that BlackRock and HC Partners may have controlled the Reorganization process prior to its presentation to the Board and the Special Committee, which only had advisory authority. This raises doubts about whether the Special Committee could negotiate effectively. The inquiries into fair dealing and fair price are interrelated, suggesting that any shortcomings in the negotiation process could taint the price. The Plaintiff has provided enough evidence to suggest that the Reorganization's exchange ratio may have been adversely affected. Consequently, the Defendants' motions to dismiss are denied, as the Plaintiff has sufficiently alleged that BlackRock and HC Partners formed a control group, making entire fairness the appropriate standard of review, and has raised valid concerns regarding the fairness of the Reorganization.