In Firefighters’ Pension System v. Foundation Building Materials, Inc. (May 28, 2024), the Delaware Court of Chancery, at the pleading stage of litigation, declined to dismiss claims challenging the $1.37 billion sale of Foundation Building Materials, Inc. (the “Company”), to an unrelated third party in an arm’s-length transaction (the “Merger”), after the Company had gone public in an Up-C initial public offering (the “IPO”).

In connection with the IPO, the Company’s private equity fund sponsor, which controlled the Company both before and after the IPO (the “Sponsor”), had entered into a customary tax receivable agreement with the Company (the “TRA”). Under the TRA, the Sponsor was entitled to terminate the TRA upon a change of control of the Company, and in such event to receive an early termination payment (the “ETP”), calculated as the present value of the payments that the Sponsor would have received over the full term of the TRA, under certain assumptions favorable to the Sponsor.

In a 148-page opinion, Vice Chancellor Laster found it reasonably conceivable—the standard for non-dismissal of claims at the pleading stage—that the decision to sell the Company was influenced by the Sponsor’s desire to receive the ETP. The court applied entire fairness review, as it viewed the receipt of the ETP as a non-ratable benefit to the Sponsor—i.e., a benefit not shared by all of the Company’s public stockholders. The court held that the plaintiff, at the motion to dismiss stage, sufficiently pled that:

• the Sponsor, its representatives on the Company’s Board of Directors (the “Sponsor Directors”), and the Company’s CEO (collectively, the “Sponsor Defendants”) may have breached their fiduciary duty of loyalty to the minority stockholders;
• the independent directors on the Board’s Special Committee (the “Special Committee Directors”) may have breached their fiduciary duty of loyalty; and
• the financial advisors to the Board and to the Special Committee (the “Board Financial Advisor” and the “Special Committee Financial Advisor,” respectively) may have aided and abetted the fiduciary breaches.

Key Points

• Judicial focus on potential conflicts under the Up-C structure. While tax receivable agreements with early payment provisions on change of control of the company have been commonly used in Up-C IPOs, de-SPAC transactions, and other sponsor-backed IPOs, the sponsor-controller’s and financial advisors’ conflicts identified in this case have rarely been addressed by the court.
• Potentially distinguishing factors. The court may have viewed the alleged conflicts in this case as especially problematic given: (i) that the Sponsor Defendants allegedly only began pursuing a sale of the Company after legislation was enacted that would reduce the stream of contractual payments the Sponsor could expect to receive under the TRA; (ii) the Sponsor Defendants allegedly were “fixated” on the Sponsor receiving the ETP; (iii) the Special Committee allegedly was formed well after the sale process was underway, never addressed the Sponsor’s potential conflict, and was generally passive in the process and deferential to the Sponsor; (iv) allegedly, the value-maximizing option for the Company and its minority stockholders was remaining independent and paying less to the Sponsor under the TRA; (v) the Financial Advisors’ fees were tied in part to the Sponsor receiving the ETP; and (vi) the Company’s disclosure allegedly was inadequate with respect to the TRA and the Financial Advisors’ fees.

Background. In 2015, the Sponsor acquired the Company in a going-private transaction. Eighteen months later, the Sponsor took the Company public in an Up-C IPO. Post-IPO, the Sponsor owned shares representing 65.4% of the Company’s outstanding voting power; and the Board was comprised of ten members—six being principals or employees of the Sponsor, one being the Company’s CEO, and three being nominally independent. In connection with the IPO, the Sponsor and the Company entered into the TRA, which was publicly filed. On January 1, 2018, the Tax Cuts and Jobs Act of 2017 (the “Tax Act”) became effective, reducing the federal corporate income tax rate, which reduced the value of the Company’s tax assets by 40% and thus reduced the payments that the Sponsor would receive under the TRA—allegedly, making a sale of the Company and receipt of the ETP a more attractive option for the Sponsor than continuing the Company as an independent entity and receiving lower amounts under the TRA.

In early 2018, the Board commenced a sale process, led by the Sponsor Directors. “Well after the sale process was underway,” including price negotiations with bidders, the Board created the Special Committee, comprised of the Company’s three independent directors, to address the issues created by the prospect of an ETP—although, at that time, none of the bidders had expressly referenced the ETP. In 2020, the Company agreed to the Merger, which represented a 24% premium to the Company’s pre-announcement closing price. The Special Committee recommended and the Board approved the Merger. The Sponsor delivered written consent for stockholder approval of the Merger. On closing of the Merger, the Sponsor received the ETP. The plaintiff-stockholder brought suit on behalf of a putative class of minority stockholders.

Discussion

Up-C IPO structure. The Up-C structure is commonly used in connection with sponsor-backed IPOs. It enables investors in an entity structured as a limited liability company or partnership for tax purposes—as most private equity funds’ portfolio companies are—to go public while preserving many of the tax benefits of a traditional partnership. In addition, ultimately, the pre-IPO investors can liquidate their partnership units by selling them to the public in exchange for public shares on a one-to-one basis; and then the TRA specifies the percentage of the resulting tax savings enjoyed by the company because of the exchange that is allocated to the sponsor and the percentage of the resulting tax savings that is allocated to the company—frequently, 85% and 15%, respectively. After the Up-C IPO, pre-IPO investors, if they have not elected to exit the investment entirely, remain in effective control of the business through their voting control over the public company.

The TRA and ETP. Under the Company’s TRA, the Sponsor was entitled to a payment equal to 90% of any benefit the Company received from using any tax asset generated while the Company had been privately held. In the event of a change of control of the Company after the IPO, the Sponsor had the right to terminate the TRA and receive the ETP. The ETP was to be calculated as the present value of all the tax benefit payments the Company would have had to make over the term of the TRA, using a discount rate and assumptions that the court viewed as favorable to the Sponsor. Before the Tax Act, the Company estimated that over the 15-year term of the TRA the Company would pay the Sponsor about $190-220 million under the TRA. In 2017, the Company estimated that the Tax Act would cut those amounts by about one-third. When the Merger closed, the Sponsor received an ETP of $74.8 million, plus a payment of $8.6 million for tax benefits used.

Entire fairness standard of review applied. Entire fairness applies to a transaction when a controller’s interests diverge from those of the minority stockholders, including when a controller receives a non-ratable benefit in the transaction; or when a transaction is approved by a board not comprised of a majority of independent and disinterested directors. In this case, the court stated, “the decision to pursue and approve the Merger presents a straightforward scenario that satisfied both triggers.” The court stated that, although the Sponsor and the minority stockholders all received the same merger consideration for their shares, “[o]nly [the Sponsor] received the [ETP], meaning that [the Sponsor] received a non-ratable benefit.”

Sponsor Defendants’ alleged fiduciary breaches. Applying the entire fairness standard, the court found the plaintiff sufficiently pled that the Sponsor Defendants acted self-interestedly by initiating a sale process and approving the Merger so as to secure for the Sponsor the ETP as well as the consideration for its shares. The court found it reasonable to infer, based on the plaintiff’s allegations, that the Sponsor Defendants only began pursuing a sale after the Tax Act reduced the stream of contractual payments the Sponsor could expect to receive; and that, “for the Company and its minority stockholders, continuing to operate the firm as an independent entity and paying lesser amounts to [the Sponsor under the TRA] represented the value-maximizing option.” The court wrote: “In other words, it is reasonable to infer that faithful fiduciaries would not have sold the Company at all.”

Special Committee Directors’ alleged fiduciary breaches. The Committee, which was “created…to address the conflict created by the [ETP,]…charged…with determining whether a sale was advisable and [given]…the power to say ‘no’[,]…was passive…[and] took specific actions that smack of deference to the [Sponsor],” according to the court. At the same time, however, the court acknowledged that “[e]xculpation remains a strong defense, and the special committee defendants may be entitled to judgment in their favor at a later stage.”

Financial Advisors’ alleged aiding and abetting. The Financial Advisors’ contingent success fees were tied in part to the Sponsor’s receipt of the ETP. The court viewed that arrangement as aligning the Financial Advisors with the Sponsor’s interests rather than the minority stockholders’ interests. With respect to the Special Committee Financial Advisor, the court wrote: “It is one thing to pay contingent compensation to the financial advisor charged with securing the best deal reasonably available. It is another thing to pay contingent compensation to the financial advisor who is supposed to be willing to tell the special committee that the deal should not happen. Because of that different role, a special committee’s financial advisor should not receive contingent compensation…[and] certainly should not receive contingent consideration tied to the conflict that the special committee was created to address, using a compensation arrangement that the special committee and its counsel had flagged as problematic for the financial advisor representing the company.”

Materiality of ETP-tied portion of the fees. Inclusion of the ETP in the calculation of the success fees generated only an additional $448,000 for the Board Financial Advisor and $313,600 for the Special Committee Financial Advisor. However, the court rejected the argument that the ETPs’ inclusion was immaterial. The court wrote: “If so, then why did [the Sponsor] revise the [Board Financial Advisor’s] engagement letter to include it? At this stage, it is reasonable to infer that [the Sponsor] made the change believing it would affect [the advisor]’s behavior. If [the Sponsor] simply wanted [the advisor] to receive more money, [the Sponsor] could have nudged up the percentage.” With respect to the Special Committee Financial Advisor, the court wrote, “[O]nce again, why include it?” The court also found that the plaintiff sufficiently pled that the Special Committee Financial Advisor may have “acted consistent with the incentives that its engagement letter created,” as it “criticized [certain] bids, which contributed to the Board granting exclusivity to [the buyer]” and it may have “treated the Company’s obligations under the [TRA] inconsistently by factoring them in for the high-end of the ranges in its valuations, while omitting them from the low-end of the ranges…–an approach that makes little sense,” as “[e]ither the [TRA] imposed contractual obligations, as the defendants now claim, or it did not.”

Alleged disclosure breaches. The court found that the plaintiff sufficiently pled that the Information Statement failed to disclose: (i) “the role that the [TRA] played in the sale process and the Merger,…[including a lack of] meaningful information about the calculation of the [ETP] or why the payment was made”; (ii) the tying of the Financial Advisors’ fees to the ETP, although the aggregate fees for each advisor were disclosed; and (iii) the Board Financial Advisor’s and the Board’s legal advisor’s extensive relationships with the Sponsor, although their less extensive relationships with the Company were disclosed.

No fiduciary breaches in obtaining the ETP, nor conducting the sale process. Notably, the court indicated that the TRA was a valid contractual arrangement and “[t]he [Sponsor] had a contractual right to receive the [ETP]…[and] was entitled to stand on its contract right.” As the TRA pre-existed the sale of the Company, payment of the ETP “[did] not divert merger consideration; it maintain[ed] the status quo.” The court also found that the sale process itself was reasonable. The court emphasized that fiduciary breaches, if they occurred, occurred in connection with the decision to sell the Company, not in the Sponsor’s obtaining the ETP nor in the conduct of the sale process.

Practice Points

• Up-C structure litigation risks. While the structure provides significant benefits, and  FBM may well be distinguishable from other cases, parties should be aware of the potential conflicts associated with, and the recent focus of the plaintiffs’ bar on, use of the structure.
• Financial advisors’ fee structures. Where the advisor represents a special committee considering a sale of the company that would trigger an early termination payment under a tax receivable agreement, the advisor should consider not tying its fee, even in part, to the sponsor’s receipt of the early termination payment. Careful consideration should be given to when disclosure of the separate elements of the fees may be prudent, rather than disclosure only of the aggregate fees. Also, note that a sponsor’s adding, rather than a financial advisor’s requesting, certain compensation potentially could lead the court to infer that that compensation, even if minimal in amount, is material.
• In connection with a decision to sell a company following its Up-C IPO: (i) the sponsor, company directors, and advisors should consider and address the conflicts created by an early termination payment under a tax receivable agreement; (ii) the sponsor should not be fixated on obtaining an early termination payment under a tax receivable agreement; (iii) the sponsor and the company’s board should consider and document the business reasons for the sale other than the sponsor’s receiving an early termination payment; and (iv) the special committee should be created at the outset of the sale process, should focus on protecting the interests of the minority stockholders, should not consider a sale of the company to be a fait accompli, and should be proactive in the sale process and not simply defer to the sponsor. The special committee and the board should carefully consider the benefits and disadvantages, to the corporation and its stockholders as a whole, of selling the company versus its continuing as an independent company. We expect that future decisions in similar situations likely will be evaluated on a continuum, based on the strength of the record with respect to: the financial analysis supporting the value proposition for a sale of the company as opposed to its remaining independent; the independence and efforts of the special committee and the board; the independence of the financial advisors, including with respect to the structure of their fees; and the adequacy of the disclosure.