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In Re Carvana Co. Stockholders Litigation
Citation: Not availableDocket: C.A. No. 2020-0415
Court: Court of Chancery of Delaware; June 30, 2022; Delaware; State Appellate Court
Original Court Document: View Document
In the case of Carvana Co. Consolidated Stockholders Litigation, the Court of Chancery of Delaware addressed claims against Ernest Garcia II and Ernest Garcia III regarding a $600 million stock sale during a period of significant stock price decline due to pandemic-related market volatility. The sale price of $45 per share was criticized as being below fair value, particularly as public stockholders were excluded from this Direct Offering, which the Garcias participated in by purchasing $50 million of stock. The stockholder plaintiffs alleged breaches of fiduciary duties by the Garcias. Carvana and Garcia Junior's motions to dismiss these claims on the grounds of failure to plead demand futility and failure to state a claim were denied. Garcia Senior's motion to dismiss for lack of personal jurisdiction is to be addressed separately. The factual background highlights that Carvana was founded by the Garcias, who control the majority of its voting stock, and notes Garcia Senior's troubled history with legal and financial issues prior to forming Carvana. Carvana was established in 2012 as a subsidiary of DriveTime, with Garcia Junior serving as its CEO, President, and Chairman. In 2017, DriveTime spun off Carvana, creating a publicly traded holding company that owns Carvana Group, LLC. Carvana employs a dual-class capital structure: Class A shares are publicly traded with one vote each, while Class B shares, controlled by the Garcias, have ten votes each. The Garcias hold 92% of Carvana's voting power through ownership of approximately 88.4 million Class B shares. The board consists of six members, including Garcia Junior, with plaintiffs alleging close ties between board members Sullivan and Platt and the Garcias, as well as significant director fees received by Sullivan and Platt prior to the lawsuit. In February 2020, stock markets crashed due to the COVID-19 pandemic, causing Carvana's stock price to plummet from $110 to below $30. Despite this, internal communications indicated that Carvana did not urgently need to raise capital. Garcia Junior declined a Goldman Sachs proposal for convertible debt and opted for cost-cutting measures instead. On March 24, 2020, Carvana secured a $2 billion finance agreement with Ally Financial, leading to a significant rise in its stock price. However, on the same day, despite its strong financial standing, Carvana initiated discussions for a capital raise with Greenoaks Capital and existing investors. Garcia Junior and Greenoaks negotiated a convertible preferred stock issuance by Carvana, with Greenoaks committing $200 million and the Garcias at least $50 million. Garcia Junior selected investors for the non-public offering and reviewed potential participants. An urgent Board meeting was called on short notice to discuss a preferred stock issuance, with a potential investor seeking $300–$500 million. Plans for a follow-up meeting were canceled when it became clear a deal couldn't be approved before market opening. Garcia Junior and Carvana’s General Counsel, Paul Breaux, continued to negotiate with investors. On March 25, the Board held two telephonic meetings where Garcia Junior updated them on the capital raise and alternatives. The meeting minutes did not indicate a discussion on the necessity of the capital raise. Following Garcia Junior's instructions, Breaux and Mike Levin worked overnight to prepare a conceptual agreement. On March 26, the Board met twice; the first meeting included updates on a potential equity transaction, while Jenkins presented a slide deck outlining Carvana's COVID-19 response, indicating the company could manage an 80% sales drop without additional financing and had $430 million in liquid assets. The presentation did not mention a need for further capital. During the second March 26 meeting, Garcia Junior updated the Board on negotiations for the capital raise. Breaux later sent directors resolutions for approval, indicating a shift to a common stock offering instead of preferred stock due to limitations imposed by the company's senior notes on the amount of common stock convertible from preferred stock, which could limit the Garcias' equity acquisition potential. This shift is inferred as reasonable by the plaintiffs. The Board was not informed of any urgent need for the Company to raise capital prior to approving a Direct Offering. On March 26, 2020, Carvana’s Class A common stock closed at $56.55 per share. During a telephonic meeting on March 27, 2020, led by Garcia Junior, the Board discussed the Company's potential equity transaction. Garcia Junior and Platt were absent during the vote, which was conducted by Maroone, Parikh, Quayle, and Sullivan, who noted interest from multiple investors to participate in a capital raise. The Board approved the Direct Offering, which was similar to the previously sent resolutions outlining an investment agreement with the Garcias, a price range of $45 to $55 per share, and a total raise of approximately $600 million. Later that day, the stock closed at $49.04 per share. The resolutions granted management the authority to negotiate the terms of the investment agreements, allowing Garcia Junior, as CEO, to negotiate terms with himself and his father, Garcia Senior. Although certain terms required Board approval, there were no documents indicating that the Board reviewed or approved any agreements. The Direct Offering was oversubscribed, with the Garcias investing $25 million each, purchasing 555,556 shares at the lowest authorized price of $45 per share. Garcia Senior was involved in planning the offering, and on March 29, Garcia Junior communicated the final decisions to the Board. The offering was announced and closed on March 30, 2020, and a prospectus filed on March 31 stated the proceeds would be used for general corporate purposes without a specific material use identified. An update on April 5 emphasized the offering as a defensive measure amid economic uncertainty. On May 6, 2020, Carvana reported strong first-quarter earnings, indicating a 43% increase in car sales and a 45% increase in revenue year-over-year. Garcia Junior expressed confidence that the company would benefit from the COVID-19 pandemic due to the surge in e-commerce. Following this announcement, Carvana’s stock price rose to $97.67, more than double the price from the Direct Offering two months prior. The Garcias were aware of this favorable performance before the Direct Offering. On May 18, Carvana announced a public offering of five million Class A shares at $92 each, approved in a brief Board meeting. Garcia Senior initiated a Rule 10b5-1 trading plan on June 15 to profit from shares purchased in the Direct Offering. On August 6, Carvana reported a 25% increase in retail units sold for the second quarter, contributing to a 28% rise in stock price to $222.99 the following day. Under the Securities and Exchange Act of 1934, the Garcias had to return profits from stock sales within the six-month short-swing period, which ended on September 30, 2020. After this period, Garcia Senior sold millions of shares, including 2 million on December 2 for $478.4 million, while modifying his trading plan twice and remaining the controlling stockholder. Litigation arose when St. Paul Electrical Construction Pension Plan and others filed a complaint against Carvana on May 28, 2020, challenging the Direct Offering. Other shareholders also demanded records under Delaware law, leading to several complaints, including a consolidated plenary action on January 4, 2021. On May 13, 2021, the Plaintiffs were appointed as Co-Lead Plaintiffs and filed an Amended Complaint on August 20, 2021, asserting two causes of action. Count I involved a direct breach of fiduciary duty claim by the Plaintiffs against all Defendants, which was dismissed on September 27, 2021, following the Delaware Supreme Court's ruling in Brookfield Asset Management, Inc. v. Rosson. Count II remains as a derivative claim for breach of fiduciary duty, prompting the Defendants to file motions to dismiss. These motions were fully briefed, and oral arguments occurred on March 14, 2022. Carvana and Garcia Junior moved to dismiss under Court of Chancery Rule 23.1 for failing to plead demand futility and under Rule 12(b)(6) for failure to state a claim. Garcia Senior joined the other Defendants’ motions and additionally moved to dismiss for lack of personal jurisdiction, which will be addressed separately. The court's analysis focuses on Carvana and Garcia Junior's arguments regarding Rules 23.1 and 12(b)(6). Demand futility is a critical concept in Delaware law, requiring that shareholders either demand the board pursue the claim or show that such demand is excused due to directors’ inability to make impartial decisions. Rule 23.1 necessitates stockholder plaintiffs to detail their efforts to obtain desired actions from the directors and the reasons for any failure. To establish demand futility, plaintiffs must meet heightened pleading standards and provide particularized factual statements. The Delaware Supreme Court's recent adoption of the "universal test" for demand futility, as established in the case of Zuckerberg, requires a director-by-director analysis. This includes assessing whether any director received a material benefit from the misconduct, faces a substantial likelihood of liability, or lacks independence from someone who did. If at least half of the board members meet any of these conditions, demand is deemed futile. The relevant directors for this case were identified as those serving on the Board at the time the Amended Complaint was filed. A plaintiff in a case involving an even-numbered board only needs to show conflicts with half the board members. Here, defendants acknowledge that Garcia Junior is conflicted regarding the Direct Offering. The plaintiffs do not contest the independence of directors Maroone, Parikh, or Quayle, leading to a focus on Sullivan and Platt. Plaintiffs do not claim that Sullivan and Platt have a direct interest in the Direct Offering or face a substantial likelihood of liability. Instead, they question Sullivan's and Platt's independence from the Garcias, who allegedly gained materially from the misconduct at issue. To challenge the independence of Sullivan and Platt, plaintiffs must present facts suggesting that these directors cannot act impartially due to their connections with the Garcias. Allegations of financial ties, personal relationships, or prior behaviors that indicate non-independence are critical. Plaintiffs assert that Sullivan's historical ties to Garcia Senior and director fees from Carvana create reasonable doubt about his independence. However, mere assertions of past relationships or director fees are insufficient to overcome the presumption of independence unless supported by specific factual allegations. The plaintiffs' claims against Sullivan's independence are notably strengthened by his past employment with Garcia Senior and his involvement in significant events during the Lincoln Savings and Loan scandal. This background, coupled with the director fees, forms the basis of their argument that Sullivan may be beholden to Garcia Senior, thus potentially compromising his ability to act independently in matters related to the Garcias. Sullivan was censured by the NYSE for actions taken on behalf of Garcia Senior, particularly regarding the management of Young Smith, Peacock, Inc. (YSP), which Sullivan joined as managing director in 1987. After YSP faced significant losses during the 1987 market crash, it borrowed $2.5 million from a Garcia-controlled entity, despite NYSE prohibitions against repayment due to its financial instability. Sullivan indirectly facilitated this repayment by purchasing a $2.4 million note from the same entity in early 1988, leading to his censure and a six-month suspension from supervisory roles in 1993. Despite this setback, Sullivan's career progressed when Garcia Senior hired him as a consultant for DriveTime in 1995, later promoting him to President in 1999 and Vice Chairman from 2004 to 2007. In 2001, amidst the post-9/11 market turmoil, they initiated a tender offer to take DriveTime private, culminating in a merger that made them the sole owners. After leaving DriveTime, Sullivan founded AFAR Media LLC, investing approximately $10 million of his personal funds, indicating a significant financial commitment. Reports suggest Garcia Senior also invested in AFAR and held a board position in 2016. These relationships suggest a potential conflict of interest for Sullivan, especially when considering demands to sue Garcia Senior, who has been instrumental in Sullivan’s career and financial success. The situation parallels the case of Marchand v. Barnhill, where personal and professional ties were deemed to compromise a director’s independence. In both cases, strong connections between the individuals involved raise questions about the ability to impartially evaluate legal actions against influential figures in their careers. Sullivan, after receiving a censure from the NYSE, was employed by Garcia Senior at DriveTime, where he advanced to CEO, President, and director over twelve years. His appointment to the Board suggests Garcia Senior's influence. Additionally, Garcia Senior made a significant investment in Sullivan's AFAR media company, establishing a deeper connection than the charitable contributions referenced in the Marchand case. Sullivan's past censure by the NYSE for actions benefiting Garcia Senior further complicates their relationship. Plaintiffs allege strong personal ties between Sullivan and Garcia Senior, contrasting with the Zimmerman v. Crothall case, where the court found insufficient grounds to question a director's independence based solely on friendship. The Company argues that Sullivan's ties are similarly weak; however, the allegations against Sullivan indicate a more substantial bond, including a prior NYSE violation related to Garcia Senior and financial reliance on him. Defendants maintain that individual allegations do not undermine Sullivan’s independence, advocating for a fragmented analysis. However, plaintiffs' claims must be evaluated collectively, as per legal precedent, to determine if they create reasonable doubt about Sullivan's objectivity. The Defendants’ attempts to diminish the cumulative weight of these allegations are deemed unconvincing. Comparisons to cases like In re Goldman Sachs Group, Inc. Shareholder Litigation are found inadequate, as those involved market transactions rather than personal obligations, highlighting the distinct nature of Sullivan's relationship with Garcia Senior. Plaintiffs failed to provide sufficient pleadings to demonstrate that the director's company benefited from discounted loans from Goldman Sachs or that these loans were a significant part of the company's funding. Defendants referenced the Goldman Sachs case, arguing that a prior unspecified investment by Garcia Senior in AFAR did not compromise Sullivan's independence. However, the context differs as Garcia Senior's investment was personal and significant, unlike Goldman Sachs, which involved an established bank with no personal ties. The court's ruling in Flannery is noted, where allegations of directors' independence were dismissed due to a lack of evidence regarding the controller entities' influence over their compensation or job prospects. In contrast, Garcia Senior's role as a primary investor and director at AFAR, alongside his close relationship with founder Sullivan, suggests he may have considerable influence over Sullivan, contradicting the defendants' claims that there is no evidence of substantial sway. The analysis in Flannery focused on whether a controller's investment indicates a disabling influence on a director's independence. In this case, the controller's investment is accompanied by additional factors indicating a lack of independence, including significant personal and business ties. Defendants contend that Sullivan's previous employment with Garcia Senior is not relevant, noting that this employment ended over ten years before Sullivan joined the Carvana Board and five years before Carvana's formation. They reference two cases—In re Western National Corp. Shareholders Litigation and Teamsters Union 25 Health Services Insurance Plan v. Baiera—to argue that past employment with a controller does not constitute a disabling conflict. However, both cases are distinguishable from this situation; in Western National, the director's long-term ties to American General were found insufficient to infer bias toward the controlling stockholder. In Baiera, the court ruled that a director’s previous executive role with Travelport did not negate his presumption of independence, despite close timing to his board appointment. The document emphasizes that the nature of Sullivan's relationship with Garcia Senior is more significant than the mere fact of former employment, indicating deeper ties. It cites additional precedents, such as In re Freeport-McMoran Sulphur, Inc. Shareholder Litigation, which acknowledged that extensive ties could challenge a director's independence despite formal severance. Ultimately, the plaintiffs present a compelling array of facts that create reasonable doubt regarding Sullivan’s ability to impartially assess a demand for litigation against Garcia Senior, extending this concern to Garcia Junior, who also controls Carvana. The Garcias' close personal and professional relationship with Sullivan raises doubts regarding his objectivity in considering a demand for litigation against Garcia Senior’s son, particularly concerning similar alleged wrongdoing. Plaintiffs argue that Sullivan cannot impartially evaluate pursuing litigation related to the Direct Offering against either Garcia. Platt's connections to the Garcias also create reasonable questions about his independence, though his ties are deemed less significant than Sullivan's. Allegations specify that Platt, as Managing Director at Greenwich Capital, had a long-standing banking relationship with the Garcias and DriveTime, which involved lucrative financing arrangements. These connections potentially benefited Platt financially. The plaintiffs note that Platt hired Garcia Junior for his first post-college job in 2005, and later, Garcia Junior offered an internship to Platt’s son at Carvana in 2015. The court is instructed to make plaintiff-favorable inferences, suggesting that Platt’s relationship with the Garcias likely influenced the opportunities afforded to his son. Additionally, Garcia Senior appointed Platt to directorships at multiple Garcia-controlled entities, including DriveTime and Carvana, from which Platt has received over $1 million in compensation. His relationship with the Garcias has provided him access to exclusive investment opportunities, generating tens of millions in profit. Notably, Platt received 200,000 Class B common units from Carvana, a benefit not extended to other directors, and has profited significantly from converting these units into Class A shares. Furthermore, his investment entity was permitted to acquire exclusive Class C preferred units in Carvana, with access restricted to a select few. In the 2017 IPO of Carvana, all Class C preferred units converted to Class A common units on a one-to-one basis, and holders of Class A common units received 0.8 Class B common shares. Class A common units can be exchanged for shares of Carvana Class A common stock. Platt has profited significantly by exchanging and selling these Class A units, generating millions of dollars. Additionally, Platt and GV Auto I, LLC entered into a tax receivable agreement with Carvana, allowing them to receive 85% of certain benefits, raising questions about Platt's independence from the Garcias. Key allegations include the conversion and sale of Class B units, from which Platt has made over $24 million, and preferential investment opportunities in Carvana Group, LLC. The court has established that past benefits from a controller may create a sense of obligation that can compromise a director's loyalty to the corporation. This precedent suggests that Platt's financial gains and exclusive investment opportunities could reasonably lead to doubts about his independence. Defendants argue that Platt’s compensation is typical for equity incentives and that no other board members received similar offers, but provide no rationale for this disparity. They cite cases where directors with substantial stock ownership were deemed to have aligned interests with the company, contrasting with the situation of Platt, whose financial ties to the Garcias could undermine his independence. A director was deemed not independent due to receiving significant gifts from the controlling stockholder, including early models of Tesla cars. The court highlighted that the director's past affiliations and financial contributions to an institution, where he held a notable position, further indicated his lack of independence. The case presented involved a director, Platt, who allegedly received a substantial stock gift from the Garcias, which distinguished his situation from other cases cited by Defendants, where no such gifts were involved. Additional factors raising questions about Platt’s independence included: securing employment for Garcia Junior and his son, numerous board appointments in Garcia-controlled entities with compensation, and a historical banking relationship with Garcia Senior. Defendants argued that the allegations regarding these relationships lacked specificity and materiality, but the court noted that the cumulative effect of the relationships and interests was sufficient to challenge Platt's independence. The ruling emphasized that while individual allegations about board appointments or compensation might not alone defeat independence, the overall context of Platt's connections to the Garcias warranted further examination, thus preventing a motion to dismiss. A person typically becomes a corporate director through appointment, but mere appointment by a controller does not negate the presumption of that director's independence, as established in Friedman v. Dolan. In the case of Teamsters Local 237 Additional Sec. Benefit Fund v. Caruso, a lack of independence was not found because the plaintiffs failed to show that a director's income was materially affected by their relationship with the chairman/CEO or that their director fees were significant. Furthermore, director compensation alone cannot raise doubts about impartiality. The Complaint did not provide adequate assertions regarding the materiality of $400,000 in annual revenue received by Audio from The Limited and its affiliates, nor did it establish how Kollat might have benefited from it, leading to a failure in pleading reasonable doubt about Kollat's independence. However, the plaintiffs successfully raised concerns about the independence of directors Platt and Sullivan in relation to the Garcias, satisfying the third prong of the Zuckerberg standard, resulting in the denial of the defendants' motion to dismiss Count II under Rule 23.1. Regarding the motion to dismiss the Amended Complaint under Rule 12(b)(6) by the Garcias, the court evaluates whether it states a claim against Garcia Junior. The Delaware standard requires a reasonable conception of the claim, accepting all well-pleaded factual allegations as true but not conclusory statements lacking factual support. The court will draw reasonable inferences in favor of the plaintiff and deny the motion unless no recovery is conceivable under any scenario. Garcia Junior's argument for dismissal hinges on his claimed recusal from approving the Direct Offering; however, the facts indicate it was more akin to abstention rather than formal recusal. Defendants contend that the Direct Offering should be evaluated under the business judgment standard rather than the entire fairness standard, asserting that the Amended Complaint fails to satisfy the business judgment criteria. A director typically cannot be held liable for a wrongful board decision if they did not participate in the transaction approval process. However, abstaining from a vote does not exempt a director from liability at the motion to dismiss stage. Courts have clarified that there is no absolute protection for directors who abstain, particularly when factual circumstances surrounding abstention arise. Liability may still attach if a director was significantly involved in the transaction, participated in its negotiation or structuring, or deliberately absented themselves from meetings to evade liability. In this case, plaintiffs allege that Garcia Junior was actively engaged in the Direct Offering's development, indicating that his abstention does not warrant dismissal at this stage. Specifically, he was involved in discussions regarding the capital raise and led conversations during board meetings about the offering. The court found sufficient grounds to deny Garcia Junior's motion to dismiss a complaint regarding a Direct Offering, based on multiple allegations that raise concerns about the application of abstention principles. The plaintiffs assert that the Direct Offering should be evaluated under the entire fairness standard, which is applicable when a controlling stockholder is involved in a conflicted transaction, especially if there is not a majority of independent directors. In this case, half of the Board is deemed conflicted, as inferred from prior decisions that indicated Sullivan and Platt are beholden to the Garcias. Garcia Junior contends that the business judgment rule applies because he claims no conflict regarding the Direct Offering, arguing that the Garcias suffered from voting and economic dilution. However, it is alleged that the Garcias, who own a significant economic interest in Carvana, benefited disproportionately from the offering's pricing, which was below the market value at the time of execution. The plaintiffs maintain that the Garcias were able to participate in the deal while public stockholders were excluded, suggesting that they received a material non-ratable benefit. Given these allegations and the fact-intensive nature of determining entire fairness, the court concluded that dismissal would not be appropriate at this stage. Consequently, both Garcia Junior's motion to dismiss under Rule 12(b)(6) and Carvana's motion to dismiss under Court of Chancery Rule 23.1 were denied.