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Garfield v. Blackrock Mortgage Ventures, LLC

Court of Chancery of Delaware

December 20, 2019


          Submitted: September 10, 2019

          Kurt M. Heyman, Aaron M. Nelson, HEYMAN ENERIO GATTUSO & HIRZEL LLP, Wilmington, Delaware; Jason M. Leviton, Joel A. Fleming, Amanda R. Crawford, BLOCK & LEVITON LLP, Boston, Massachusetts; Counsel for Plaintiff Robert Garfield.

          Kenneth J. Nachbar, MORRIS NICHOLS ARSHT & TUNNELL, Wilmington, Delaware; Deborah S. Birnbach, Jennifer B. Luz, Katherine B. Dacey, GOODWIN PROCTER LLP, Boston, Massachusetts; Counsel for Defendants Stanford L. Kurland, David A. Spector, Anne D. McCallion, Matthew Botein, Farhad Nanji, Mark Wiedman, Joseph Mazzella, Andrew S. Chang, and Nominal Defendant PennyMac Financial Services, Inc.

          Kevin R. Shannon, Berton W. Ashman, Jr., Callan R. Jackson, POTTER ANDERSON & CORROON LLP, Wilmington, Delaware; John P. Coffey, Adina C. Levine, KRAMER LEVIN NAFTALIS & FRANKEL LLP, New York, New York; Counsel for Defendants BlackRock Mortgage Ventures, LLC and BlackRock, Inc.

          David E. Ross, S. Michael Sirkin, ROSS ARONSTAM & MORITZ LLP, Wilmington, Delaware; Counsel for Defendant HC Partners, LLC.


          McCORMICK, V.C.

         This action challenges the fairness of a reorganization that transformed PennyMac from an "Up-C" structure to a simple corporate form. The reorganization created benefits for the defendants who held units in the company's operating subsidiary, but not for the stockholders who held Class A common stock in the parent corporation. The plaintiff holds Class A common stock and argues that the reorganization should be subject to the entire fairness standard of review. The defendants moved to dismiss pursuant to Court of Chancery Rule 12(b)(6), arguing they should obtain the benefit of the business judgment rule under Corwin because a majority of disinterested stockholders approved the transaction.

         Under Delaware law, a stockholder vote cannot restore the business judgment rule under Corwin when there is a controller that benefits personally from the transaction. Following this logic, this decision finds Corwin is inapplicable because the complaint supports a reasonably conceivable inference that two large PennyMac stockholders constituted a control group that stood to benefit from the reorganization. This decision further finds that the complaint states a claim when evaluated under the entire fairness standard.


         The background facts are drawn from the Verified Amended Class Action and Derivative Complaint (the "Amended Complaint"), [1] exhibits attached to the Amended Complaint, documents it incorporates by reference, and any judicially noticeable sources.

         A. BlackRock and HC Partners Launch PennyMac.

         During the financial crisis of 2008, BlackRock, Inc.[2] and Highfields Capital Management ("HC Partners")[3] perceived a market opportunity to acquire loans from financial institutions who were "seeking to reduce their mortgage exposures."[4] For that purpose, they formed Private National Mortgage Acceptance Company, LLC ("PennyMac, LLC"). The press release announcing PennyMac, LLC's formation referred to BlackRock and HC Partners as "strategic partners" who could "enhanc[e] PennyMac's relationships with global financial institutions and provid[e] valuable input in structuring PennyMac's investment management activities."[5] BlackRock and HC Partners signed the PennyMac LLC Agreement (the "LLC Agreement"), [6]which afforded them certain rights and preferences. These included the right to veto certain LLC actions and to call an official meeting at any time.

         In 2009, PennyMac, LLC formed PennyMac Mortgage Investment Trust (the "Public REIT"). The Public REIT was externally managed by PNMAC Capital Management, LLC (the "REIT Manager"), a subsidiary of PennyMac, LLC. In its initial public offering, the Public REIT sold 93.5% of its shares to public investors and 6.5% of its shares to BlackRock, HC Partners, and management. The offering documents again described BlackRock and HC Partners as "strategic partners."[7]

         B. The Up-C Transaction

         In 2013, BlackRock, HC Partners, and former PennyMac CEO Stanford L. Kurland took the PennyMac structure public in an "Up-C" transaction. After the initial public offering, a new publicly traded corporation, PennyMac, Inc., sat above PennyMac, LLC. PennyMac, Inc. issued Class A common stock to the new public stockholders who participated in the public offering. These Class A common stockholders owned 15% of the voting rights and 100% of the economic rights to PennyMac, Inc. PennyMac, Inc. also issued Class B common stock to existing PennyMac, LLC Unitholders (the "LLC Unitholders"). The LLC Unitholders held the remaining 85% of the voting rights of PennyMac, Inc. through their Class B shares; they continued to derive their economic benefits solely from ownership of the subsidiary LLC. For ease, this decision refers to PennyMac, Inc. and PennyMac, LLC together as "PennyMac" unless a distinction is necessary.

         The Up-C public offering documents described BlackRock and HC Partners as "strategic investors" who supported PennyMac's senior management in "organizing] PennyMac and assembl[ing] a team with the knowledge and experience" to identify market opportunities and create value for stockholders.[8]PennyMac, LLC's filings in connection with the public offering also describe BlackRock and HC Partners as "strategic partners" who, along with members of management, founded the original LLC.[9]

         C. IPO-Related Agreements

         Two agreements executed in conjunction with the 2013 Up-C transaction allowed the LLC Unitholders to take advantage of the tax-friendly Up-C structure. The first, the "Exchange Agreement," allowed LLC Unitholders to exchange their LLC Units for Class A common stock in PennyMac, Inc. on a one-for-one basis. These exchanges created potential tax liability for the LLC Unitholder but provided potential tax benefits to PennyMac, Inc. The second, the "Tax Receivable Agreement," entitled LLC Unitholders to payment of 85% of any such tax benefit enjoyed by PennyMac, Inc. Thus, only 15% of any tax benefits from these exchanges remained with the PennyMac, Inc. Blackrock and HC Partners are cosignatories the Tax Receivable Agreement.

         D. Lead Up to the Reorganization

         Although the Up-C structure was designed in part to allow LLC Unitholders to more easily realize tax benefits, these benefits did not materialize for two reasons. First, the federal government passed the Tax Cuts and Jobs Act of 2017, which reduced the top marginal corporate tax rate from 35% to 21%. This reduction in the tax rate reduced the expected future value of PennyMac, LLC's tax assets accumulated due to historical net operating losses. Separately, PennyMac, LLC's business changed. Its loan production volume grew significantly, and tax laws allowed it to defer revenue associated with mortgage servicing rights. This deferral resulted in current period tax losses for PennyMac, LLC.

         Given these changes, management did not expect to earn taxable income for at least a decade, which would render the tax benefits afforded by the Up-C structure irrelevant.[10] As the Amended Complaint explains, "[t]here is no need to avoid double taxation if you do not have taxable income."[11] The LLC Unitholders thus faced a problem: the Up-C structure was a wash for them and it limited their access to the liquidity of public markets, but exchanging their units for shares of Class A common stock would be treated as a taxable event taxed as ordinary income rather than capital gains. All of the defendants owned significantly more LLC Units than Class A common stock and thus faced the same dilemma.[12]

         E. The Reorganization

         On February 28, 2018, Kurland introduced the idea of a capital structure reorganization (the "Reorganization") to the PennyMac, Inc. Board of Directors (the "Board"). After Kurland introduced the proposal, the Board "requested that management present potential ways to reorganize the Company and authorized management to discuss potential reorganization options with the holders of our Class B common stock."[13] The Reorganization was designed to allow all of the LLC Unitholders to exchange their LLC Units for PennyMac, Inc. Class A common stock in a tax-free exchange and receive long-term capital gains treatment on future sales of the newly acquired Class A common stock as long as those shares were held for more than one year.[14]

         Approval of the Reorganization required a majority vote of the PennyMac, Inc. stockholders voting as a single class.[15] As discussed above, Class A common stockholders controlled 15% of the voting rights under the Up-C structure, while LLC Unitholders controlled the remaining 85% through their ownership of Class B common stock. At the time the Reorganization was proposed, there were 25.2 million outstanding shares of Class A common stock and 52.3 million shares of Class B common stock for a combined total of 77.5 million votes. Through their respective holdings, Kurland controlled approximately 8.3 million (10.7%) of those votes;[16] BlackRock controlled approximately 15.6 million (20.1%) of those votes;[17]and HC Partners controlled approximately 20.2 million of those votes (26%);[18]Thus, the proponent of the Reorganization-Kurland-required the support of only BlackRock and HC Partners to approve the Reorganization.

         Eleven persons comprised the Board that recommended stockholders vote in favor of the Reorganization. Seven directors, all named as defendants in this action (the "Director Defendants"), [19] owned more LLC Units than shares of Class A common stock. Of the Director Defendants: BlackRock appointed one of its employees and one of its consultants, Mark Wiedman and Matthew Botein, respectively; HC Partners appointed its general counsel and a former employee, Joseph Mazella and Farhad Nanji, respectively; and PennyMac, Inc. officers Kurland, David A. Spector, and Anne D. McCallion also served. The remaining directors were James Hunt, Patrick Kinsella, Theodore Tozer, and Emily Youssouf, none of whom are named as defendants to this lawsuit.

         Members of PennyMac, Inc. management made a presentation to Blackrock and HC Partners contemporaneously concerning the Reorganization on April 24, 2018. The presentation depicted BlackRock, HC Partners, and management as a single group. It also quantified the size of the tax savings for parties subject to the individual rate to be approximately $3.21 per Unit. This quantification relied upon various assumptions relating to the party's tax situation, including that the party was a California resident with a specified tax basis and subject to the highest marginal state and federal tax rates. A week later, management held a conference call with BlackRock and HC Partners regarding the proposed transaction.

         Management made a formal presentation to the Board about the proposed transaction on May 30, 2018. Kurland opened the Board's discussion by noting that BlackRock and HC Partners were "inclined to support the proposal."[20] Kurland then turned the meeting over to Chang and attorneys from Goodwin Procter LLP ("Goodwin Procter"). According to the minutes of the meeting, Chang identified the benefits of the Reorganization, which included "more favorable tax treatment for [LLC] unit holders."[21] BlackRock had conducted its own internal evaluation of the Reorganization considering possible future scenarios depending on a variety of differing assumptions regarding PennyMac's profitability. Wiedman offered to make BlackRock's analysis available to the Board as well.

         The next day, the Board established a special committee comprised of Hunt, Kinsella, Tozer, and Youssouf (the "Special Committee") to evaluate the Reorganization. The resolution forming the Special Committee provided that "after having made a decision with respect to the Potential Transaction, the Special Committee's authority shall be limited to making a recommendation to the Board of Directors, rather than giving final approval to or implementing such action or transaction."[22]

         On June 2, 2018, the Special Committee held a conference call with management and Goodwin Procter. According to the minutes of that meeting, "[o]ne of the Committee members asked whether the Committee should consider retaining independent counsel."[23] The Special Committee never retained another law firm, and Goodwin Procter was its sole legal advisor.

         On June 11, 2018, management presented the Special Committee with an analysis showing that the Reorganization would reduce PennyMac, Inc.'s book value from $20.61 per share to $19.65 per share. The next day, the Special Committee held a conference call with management and Goodwin Procter to discuss this decline.

         On June 15, 2018, the Special Committee met and discussed whether PennyMac, Inc. should issue a special dividend (the "Distribution") to the holders of Class A common stock. Later that day, the Special Committee convened telephonically, along with Wiedman and another BlackRock managing director, Tom Wojcik. Wojcik shared that "in BlackRock's opinion, the various benefits resulting from the [Reorganization] were likely to outweigh the loss of BlackRock's potential benefits under the Company's Tax Receivable Agreement."[24]

         Two weeks later on June 29, 2018, the Special Committee met and discussed "the excess cash that accumulated at the [PennyMac, Inc.] level since the IPO in 2013 as a result of, among other things, tax distributions from [PennyMac, LLC] that exceeded [PennyMac, Inc.'s] actual tax liability."[25] The Special Committee discussed two possible alternatives to "distribute some or all of this value to Class A common stockholders."[26] The first alternative was the Distribution, and the second was to adjust the ratio of shares to be issued to holders of Class A common stock in connection with the Reorganization. On July 13, 2018, the Special Committee met with Goodwin Procter, Chang, and other members of management to review a presentation regarding the two alternatives. Chang recommended the Distribution instead of a change to the exchange ratio.

         On July 18, 2018, the Special Committee acted by written consent to recommend approval of the Reorganization to the full Board. As a condition precedent to the Reorganization, PennyMac, Inc. Class A common stockholders would receive the Distribution of approximately $10.1 million ($0.40 per share).

         On July 24, 2018, the full Board met and approved the Reorganization. The Board also directed the officers of PennyMac, Inc. to attempt to cause each of the LLC Unitholders to execute and become party to the proposed contribution agreement and plan of merger.

         At some point before the Board next convened, HC Partners and Blackrock negotiated to revise the terms of the Reorganization "adding a provision stating that the consent of BlackRock and [HC Partners] was required to terminate the Reorganization prior to the effective date."[27] On August 2, 2018, the full Board met to approve the revised proposed contribution agreement and plan of merger that reflected these changes.[28]

         The Reorganization was not conditioned on majority-of-the-minority approval. Rather, the Proxy informs that "[e]ven if no affirmative votes of Class A common stockholders are cast in favor of the Reorganization Proposal, the Reorganization Proposal will be approved if a sufficient number of votes of Class B common stockholders [i.e., [LLC Unitholders]] are cast in favor of the Reorganization Proposal."[29]

         On August 2, 2018, the Board declared and publicly announced the Distribution, which was issued on or around August 30, 2018. Later that day, PennyMac, Inc. publicly announced the Reorganization. PennyMac, Inc. issued the Proxy on September 18, 2018. Stockholders voted to approve the Reorganization on October 24, 2018, and the Reorganization closed on November 1, 2018.

         F. The Proxy and the Stockholder Vote

         The Amended Complaint alleges that the stockholder vote was uninformed and identifies two categories of disclosure deficiencies concerning (1) projections of PennyMac's future profitability and (2) the quantification of tax benefits for LLC Unitholders.

         1. Projections

         The Amended Complaint alleges that the following Proxy disclosure regarding projections for PennyMac's future profitability is incomplete:

On June 15 ... the Special Committee held a conference call with BlackRock regarding forecasts and estimates that were provided to the Special Committee by management and sought BlackRock's views on the benefits of the reorganization transaction versus the benefits under the Tax Receivable Agreement. The forecasts and estimates prepared by management primarily showed that [PennyMac, Inc.] would not generate taxable income in the near-term and minimal taxable income in the long-term. As a result, the forecasts and estimates helped advise the Special Committee that the net present value of potential benefits to holders of Class A Common Stock resulting from future exchanges of [PennyMac, LLC Units] would likely be nominal.[30]

         Plaintiff contends that a number of additional facts regarding management's projections are material and merited disclosure.

         First, in the Special Committee's June 12, 2018, meeting, one of the Special Committee members asked whether the Company would provide earnings forecasts. Chang confirmed the Company would not, even though there was significant discussion "with respect to the relevance of the earnings projections to the Company's Class A common stockholders in contrast to [PennyMac, LLC's] unit holders."[31]

         Second, On April 24, 2018, BlackRock and HC Partners reviewed the first presentation regarding the Reorganization that contained management base-case projections. The Board reviewed these same projections during its meeting on May 30, 2018.

         Third, BlackRock subsequently requested that management run three additional scenarios, which included:

Mid Growth Scenario (5% market growth) - halfway between management base case market share and the steady state scenario below
Steady State Scenario (5% market growth) - No market share gains, just market growth at 5% from 2020 onwards (2018 and 2019 are the average of Fannie/Freddie/MBA forecasts)
Steady State Scenario (2.5% market growth) - No market share gains, just market growth at 2.5% from 2020 onwards (2018 and 2019 are the average of ...

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