CURRENT MONTH (March 2024)
By Nastassia Merlino, NYU School of Law
Controlling shareholders of Carvana Co., Ernest Garcia II and Ernest Garcia III, participated in a direct offering by Carvana Co. made in late March 2020 after which Ernest Garcia II sold over $1 billion of his shares. The plaintiff shareholders asserted that the Garcias breached their fiduciary duties by acquiring shares at a depressed price through the direct offering, which allowed them to enrich themselves. As a response, Carvana Co. created a two-person special litigation committee that conducted a seven-month-long investigation and concluded that no wrongdoing occurred. As such, the committee moved to dismiss the lawsuit, and the motion was granted by the Delaware Court of Chancery on March 27, 2024.
Carvana is an online retailer for used cars that also offers financing services and connects customers to insurance providers. Ernest Garcia III co-founded Carvana in 2012 and is its acting CEO, president, and board chairman. Following the COVID-19 pandemic, Carvana had to cut costs and lay off employees, which led to weakening operational performance, causing its stock price to drop 40 percent in one week and leading the company to seek further capital-raising opportunities. On March 26, 2020, Carvana’s CFO proposed twenty-four potential investors to the board of directors for a direct offering. T. Rowe Price Group, the anchor investor, and Tiger Global Management offered $45 per share relative to the $56.55 trading price at close on March 26. The Garcias agreed to contribute $50 million as part of the capital-raising effort despite the direct offering being oversubscribed. Carvana then issued Class A Common Stock as part of its public offering at more than $92 per share on May 18, leading the stock price up to $239.54 by year-end. Ernest Garcia II then sold 5,567,979 shares of the Class A Common Stock between October and December 2020, for $1,239,333,468.02.
Three shareholders filed complaints between May and December 2020, alleging a breach of fiduciary duties by the Garcias by “forcing the Direct Offering at an artificially low price.”
To investigate the complaint, Carvana formed the special litigation committee (SLC) in August 2022 and appointed two board directors who had approved the direct offering. The investigation lasted seven months and resulted in a 170-page report, concluding that “the costs associated with continuing to pursue the Action or any other claims in connection with the Direct Offering outweigh any benefits [and the] claims against the Garcias for alleged breaches of fiduciary duty lack merit (whether assessed under the business judgment rule or the entire fairness standard).” Further, the committee concluded that the board was independent in the process, the $45 price was within a fair range, and “the investigatory record [did] not support that Garcia III’s role in [] negotiations led to the terms of the Direct Offering being any less favorable to Carvana.”
The Court of Chancery evaluated the SLC’s motion to dismiss under Zapata Corporation v. Maldonado’s two-step analysis, whereby “a special litigation committee has the burden to show its independence and that it undertook, in good faith, an investigation of reasonable scope that yielded reasonable bases supporting its conclusions” before it applies its own business judgement in determining if a dismissal would be in the corporation’s best interests.
Focusing on impartiality and objectivity, the court found that the SLC successfully proved its independence on several grounds. It found that “[a]ccepting a recommendation [for counsel] from management alone does not evidence a lack of independence of the SLC.” In addition, the fact that the SLC members had a lawsuit involving Brophy claims and a separate federal securities lawsuit involving claims of insider trading against them does not impugn their independence, as these two cases are not related to the case at hand. Further, the SLC members cannot be deemed to have prejudged the investigation simply because they approved the transaction or because they were on the board when the motion to dismiss was filed, as they did not substantively participate in the decision to file the motion. Finally, the court found that the SLC conducted a thorough and reasonable investigation in good faith, as “the SLC’s investigation and report adequately considered the allegations contained in the Complaint and evaluated the facts and law relevant to those allegations,” thus meeting its burden of reasonableness.
As the committee successfully met its burden of establishing its independence and reasonable investigation, the Court of Chancery concluded that the Special Litigation Committee’s recommended result was appropriate and thus granted its motion to dismiss.
