This article delves into the pivotal Delaware Supreme Court case, Klang v. Smith’s Food & Drug Centers, Inc., 702 A.2d 150 (1997), offering a comprehensive analysis of the court’s opinion. This case is crucial for understanding Delaware corporate law, particularly concerning capital impairment in corporate share repurchases and the fiduciary duty of candor regarding disclosure to stockholders. Smith’s Food & Drug Centers, Inc., a supermarket chain operating in the Southwestern United States, found itself at the center of this legal challenge initiated by shareholder Larry F. Klang.
Background of the Case: Merger and Self-Tender Offer
In early 1996, Smith’s Food & Drug Centers, Inc. (SFD) agreed with The Yucaipa Companies to undergo a significant transaction. This involved:
- A merger between Smitty’s Supermarkets, Inc. (a Yucaipa subsidiary) and Cactus Acquisition, Inc. (an SFD subsidiary), with SFD issuing new shares to Yucaipa.
- SFD undertaking a recapitalization, assuming new debt, retiring old debt, and offering to repurchase up to 50% of its outstanding shares (excluding those issued to Yucaipa) at $36 per share.
- SFD repurchasing preferred stock from the Smith family, who held a controlling 62.1% voting stake in Smith’s Food & Drug Centers, Inc.
To assess the financial implications, Smith’s Food & Drug Centers, Inc. engaged Houlihan Lokey Howard & Zukin (Houlihan) to provide a solvency opinion. Houlihan assured the SFD Board that these transactions would not jeopardize SFD’s solvency or impair its capital, as prohibited under 8 Del.C. § 160. Relying on Houlihan’s opinion, the SFD Board resolved on May 17, 1996, that sufficient surplus existed for the transactions. Stockholders approved the deal on May 23, 1996, and the self-tender offer was oversubscribed, leading to SFD repurchasing the full 50% of shares at $36 each.
The Court of Chancery and the Appeal
Larry F. Klang filed a class action lawsuit just before the transactions closed, naming Smith’s Food & Drug Centers, Inc., its board members, Yucaipa, and related entities as defendants. Klang challenged the transactions, alleging:
- Violation of 8 Del.C. § 160 due to capital impairment from the stock repurchases.
- Breach of fiduciary duty of candor by SFD directors for failing to disclose material facts before stockholder approval.
The Court of Chancery, after full discovery, dismissed Klang’s claims. Despite a procedural error in the dismissal order, the Delaware Supreme Court reviewed the case on appeal, focusing on the two central claims.
Capital Impairment Claim: Balance Sheets vs. Asset Revaluation
Delaware law (8 Del.C. § 160) restricts a corporation’s ability to repurchase its shares if it impairs capital, unless from “surplus” or as explicitly authorized by statute. Surplus is defined (8 Del.C. § 154) as net assets exceeding the par value of issued stock, where net assets are total assets minus total liabilities.
Klang argued that Smith’s Food & Drug Centers, Inc. violated Section 160, presenting two main arguments:
- Balance Sheet Conclusivity: Klang contended that SFD’s post-transaction balance sheets, showing a negative net worth, were conclusive proof of capital impairment.
- Inadequate Surplus Calculation: Even if off-balance-sheet surplus calculations were allowed, Klang argued SFD’s method was flawed, failing to adequately account for all assets and liabilities. He also pointed to the May 17, 1996 resolution as evidence against the board’s surplus claim.
The Supreme Court rejected both arguments, affirming the Court of Chancery’s decision in favor of Smith’s Food & Drug Centers, Inc..
Balance Sheets Are Not Conclusive
The Court clarified that balance sheets are not definitive for Section 160 compliance. It acknowledged that balance sheets might not reflect current asset and liability values due to unrealized appreciation or depreciation. The court upheld the precedent set in Morris v. Standard Gas & Electric Co., allowing corporations to revalue assets and liabilities to demonstrate surplus and comply with the statute.
The rationale is that Section 160 aims to protect creditors and the corporation’s long-term health by preventing asset depletion. Unrealized asset appreciation, although not on the balance sheet, represents real economic value. Allowing revaluation to reflect current values aligns with the statute’s purpose.
SFD Board’s Asset Revaluation Was Appropriate
Klang challenged the SFD Board’s reliance on Houlihan’s solvency opinion, arguing its methods were legally inappropriate and failed to consider all assets and liabilities. He specifically criticized Houlihan’s “market multiple” approach and the alleged omission of current liabilities. Klang also argued that the May 17, 1996 resolution contradicted the claim of sufficient surplus.
The Court disagreed, finding Houlihan’s methods and the SFD Board’s reliance on them to be acceptable.
- Methodology: The Court stated that Section 154’s definition of “net assets” is definitional and doesn’t mandate a specific calculation method. Houlihan’s use of “Total Invested Capital” and long-term debt was not inherently flawed.
- Consideration of Liabilities: The Court clarified that Houlihan’s “Total Invested Capital” calculation did account for current liabilities, meaning the analysis was net of these liabilities. Subtracting long-term debt from Total Invested Capital accurately reflected net assets.
- Board Reliance on Experts: The Court emphasized that trial courts can defer to a board’s surplus measurement unless plaintiffs prove directors failed to evaluate assets in good faith using acceptable data and methods reasonably reflecting present values. Absent bad faith or fraud, courts won’t substitute their judgment for the directors’. Klang did not allege bad faith or demonstrate unreliable methods or fraudulent surplus determination. The court also cited 8 Del.C. § 172, allowing boards to rely on experts like Houlihan.
- Resolution Error: The Court acknowledged the SFD Board’s error in the May 17 resolution, which incorrectly stated “total liabilities” as only including long-term debt. However, this drafting mistake did not invalidate the transactions. Section 160 requires surplus existence, not its formal documentation in a resolution. The repurchase’s validity isn’t contingent on a board resolution, and a documentation error doesn’t negate compliant action.
Disclosure Claims: Fiduciary Duty of Candor
Directors have a fiduciary duty to disclose all material facts reasonably available when seeking stockholder action. A material fact is one a reasonable stockholder would consider significant in deciding how to vote, altering the “total mix” of information.
Klang alleged four disclosure failures by the SFD Board:
- Non-disclosure of Houlihan’s “equity valuations.”
- Non-disclosure of pre- and post-transaction surplus amounts.
- Non-disclosure of the financing change (debt substituted for preferred stock).
- Inadequate disclosure of how the $36 self-tender price was determined.
The Court of Chancery found no disclosure violations, and the Supreme Court affirmed.
Houlihan’s Equity Valuations Were Immaterial
Houlihan’s equity valuations were accounting figures not intended to predict market price or used to set the tender offer price. Citing Barkan and Citron, the Court reiterated reluctance to mandate disclosure of purely accounting data. Such figures are poor market value predictors and could mislead stockholders. The Court deferred to the Chancery Court’s finding that these valuations wouldn’t alter the “total mix” of information.
Pre- and Post-Transaction Surplus Amounts Were Immaterial
Similarly, the Court held that disclosing precise surplus amounts was not required. Surplus, a statutory concept, doesn’t necessarily reflect corporate financial health. The Court doubted its relevance to the average stockholder’s voting decision.
The Court disagreed with a possible interpretation of In re Armsted Indus. Inc. Litig. suggesting materiality if post-repurchase surplus is above zero. The Court reasoned corporations needn’t disclose legal compliance, as stockholders generally presume legal actions. Stating “this is legal” adds nothing material to the information mix. Calculating surplus doesn’t automatically trigger disclosure obligations.
Substitution of Debt for Preferred Stock Was Immaterial
SFD’s proxy statement initially mentioned $75 million in preferred stock financing, later replaced by $75 million in debt. While this increased total liabilities by a small 0.2%, Klang argued its materiality, noting per-share debt increase and percentage increases in long-term debt and interest expense.
The Court deferred to the Chancery Court’s finding that this financing change was immaterial, given conflicting interpretations of its significance and the minimal overall impact on liabilities. The Court also noted that the change was disclosed in SEC filings incorporated by reference in the proxy statement, though it didn’t rule on whether this alone constituted adequate disclosure.
Self-Tender Offer Price Disclosure Was Adequate
The proxy statement indicated Yucaipa proposed the $36 tender price. Klang argued inadequate disclosure, suggesting the price originated from Goldman Sachs valuation. Conflicting testimony existed, but the Chancery Court found adequate disclosure. The Supreme Court deferred to this finding, as Klang presented no evidence of inadequate disclosure regarding Yucaipa’s proposal as the price source.
Conclusion: Affirming the Court of Chancery
The Delaware Supreme Court affirmed the Court of Chancery’s judgment, concluding that Smith’s Food & Drug Centers, Inc.‘s merger and self-tender offer did not violate 8 Del.C. § 160 concerning capital impairment, and the SFD Board did not breach its fiduciary duty of candor regarding disclosures to stockholders. Klang v. Smith’s Food & Drug Centers, Inc. remains a significant case in Delaware corporate law, clarifying the interpretation of capital impairment statutes and the scope of disclosure obligations in corporate transactions.
