In re Ezcorp Inc.

Decision Date25 January 2016
Docket NumberC.A. No. 9962-VCL
PartiesIN RE EZCORP INC. CONSULTING AGREEMENT DERIVATIVE LITIGATION
CourtCourt of Chancery of Delaware
MEMORANDUM OPINION

Seth. D. Rigrodsky, Brian D. Long, Gina M. Serra, Jeremy J. Reilly, RIGRODSKY & LONG, P.A., Wilmington, Delaware; Nicholas I. Porritt, Adam M. Apton, LEVI & KORSINSKY, LLP, Washington, District of Columbia; Counsel for Plaintiff Lawrence Treppel.

Edward P. Welch, Edward B. Micheletti, Cliff C. Gardner, Lauren N. Rosenello, SKADDEN, ARPS, SLATE, MEAGHER & FLOM LLP, Wilmington, Delaware; Counsel for Defendants Phillip Ean Cohen, MS Pawn Corporation, MS Pawn Limited Partnership, and Madison Park, LLC.

David C. McBride, Elena C. Norman, Nicholas J. Rohrer, Benjamin M. Potts, YOUNG, CONAWAY, STARGATT & TAYLOR, LLP, Wilmington, Delaware; Counsel for Defendant Thomas C. Roberts.

Srinivas Raju, Sarah A. Clark, RICHARDS, LAYTON & FINGER, P.A., Wilmington, Delaware; Counsel for Nominal Defendant EZCORP, Inc.

LASTER, Vice Chancellor.

Plaintiff Lawrence Treppel is a stockholder of nominal defendant EZCORP, Inc. He brought this action derivatively to challenge the fairness of three advisory services agreements between EZCORP and defendant Madison Park LLC, an entity affiliated with defendant Phillip Ean Cohen, who is EZCORP's controlling stockholder (together, the "Challenged Agreements"). Treppel regards the agreements as an unfair means by which Cohen extracted a non-ratable return from EZCORP.

The complaint originally named as defendants the individuals who served on EZCORP's board of directors (the "Board") when the Challenged Agreements were approved. The complaint also named as defendants Madison Park, Cohen, and the two entities through which Cohen controls EZCORP. Since then, Treppel has dismissed all the individual defendants except Cohen and Thomas C. Roberts, one of the directors who approved two of the Challenged Agreements while serving on the Board's Audit Committee.

The remaining defendants moved to dismiss the complaint (i) pursuant to Rule 12(b)(6) for failure to state a claim on which relief can be granted and (ii) pursuant to Rule 23.1 for failing to plead demand excusal. This decision grants the Rule 12(b)(6) motion in part, holding that Count IV of the complaint does not state a viable claim. Count III is dismissed as to Cohen on the same basis. Otherwise the motions are denied.

I. FACTUAL BACKGROUND

The facts for purposes of this decision are drawn predominantly from the Verified Amended Stockholder Derivative Complaint (the "Complaint") and the documents it incorporates by reference. Some additional facts are drawn from documents which thedefendants identified as subject to judicial notice. See In re General Motors (Hughes) S'holder Litig., 897 A.2d 162, 169 (Del. 2006). Despite having introduced and relied on those documents in their opening briefs, the defendants contended that Treppel could not refer to them in his answering brief, claiming that for him to do so would be to permit a plaintiff to rely on material outside the complaint. By making this inequitable argument, the defendants hoped to eat their cake (by going beyond the pleadings to rely on documents they chose and introduced) while still having it (by preventing Treppel from citing or arguing for inferences from the same documents).

The rule barring a plaintiff from introducing new material in an answering brief seeks to limit the extent to which the basis for a judicial decision can shift during briefing and guards against unfair prejudice to the defendants. These considerations do not apply when the defendants themselves introduce documents with their opening brief and argue persuasively that the materials are subject to judicial notice. At that point, the plaintiff and the court can rely on them as well.

The allegations of the Complaint and the documents suitable for consideration at the pleadings stage could support inferences that would favor either the plaintiff or the defendants. At this procedural stage, the plaintiff receives the benefit of all reasonable inferences. See Parts II & III, infra.

A. The Company

EZCORP is a Delaware corporation with its headquarters in Austin, Texas. It provides instant cash solutions through a variety of products and services, including pawn loans, other short-term consumer loans, and purchases of customer merchandise.

EZCORP has two classes of stock: Class A Non-Voting Common Stock and Class B Voting Common Stock. The Class A stock trades publicly on NASDAQ under the ticker symbol "EZPW." Defendant MS Pawn L.P., a Delaware limited partnership, owns all of the Class B stock.

MS Pawn L.P. is controlled by its sole general partner, MS Pawn Corp. Cohen is the sole owner of the stock of MS Pawn Corp. Through MS Pawn L.P. and MS Pawn Corp. (together, "MS Pawn"), Cohen controls EZCORP.

One consequence of EZCORP's capital structure is that Cohen controls 100% of EZCORP's voting power despite owning only a minority of its equity. As of June 30, 2014, there were 50,612,246 shares of Class A stock outstanding, but only 2,970,171 shares of Class B stock outstanding. Except for voting rights carried by the Class B shares, the rights, powers, privileges, and preferences of the two classes of stock are functionally identical. The Class B shares through which Cohen controls EZCORP thus represent only 5.5% of the outstanding stock.

As control rights diverge from equity ownership, the controller has heightened incentives to engage in related-party transactions and cause the corporation to make other forms of non-pro rata transfers. Economists call this "tunneling." See Simon Johnson et al., Tunneling, 90 Am. Econ. Rev. 22 (2000). The basic insight is a simple one: by virtue of its control over the firm, the controller can direct how that firm deploys its capital. As an equity owner, the controller participates in the resulting benefits (and losses) in proportion to its equity stake, effectively gaining or losing on a pro rata basis with other stockholders. By contrast, in a related-party transaction, the controller receives 100% ofthe benefit while only funding the payment to the extent of its equity stake. The balance of the payment is funded by the unaffiliated equity holders. The economic incentive to tunnel varies inversely with the controller's equity stake. All else equal, as the controller's equity stake declines, the relative benefit from a direct payment increase.1

To use a simple example, assume that EZCORP had sufficient net profits available to pay a dividend of $0.10 per share. The total cost of the dividend would be $5.36million ($0.10 * 53,582,417 total shares outstanding). If Cohen owned 100% of the outstanding shares, then there would be no difference (ignoring tax effects) between having EZCORP declare the dividend on all shares versus paying Cohen $5.36 million directly under a services agreement or other form of contract. But as Cohen's assumed level of equity ownership declines, so does his share of a dividend, making the alternative of direct contractual compensation more attractive. At 51% equity ownership, Cohen would receive just over half of a dividend ($2.7 million), but he would receive all of a contractual payment. EZCORP's dual class structure makes the difference even more dramatic. Through the Class B shares, Cohen would receive only $297,017 from the dividend ($0.10 * 2,970,171 Class B shares) with the other 94% of the value going to the Class A shares. If EZCORP deployed the same $5.36 million of available cash to pay for advisory services from a Cohen entity, then Cohen would receive the entire $5.36 million while only indirectly bearing 5.5% of the cost through his equity stake. He would come out ahead by $5.065 million.

EZCORP's market capitalization is not large. On September 8, 2015 (the date of oral argument on the motions to dismiss), the Class A stock closed at $6.10 per share. The trading price implied an equity value of $326 million. As of January 21, 2016, the Class A stock closed at $3.29 per share. That figure represents a substantial discount from the shares' peak at $35.58 per share in May 2011.

B. The Predecessor Agreements

EZCORP has a history of entering into advisory services agreements with entities affiliated with Cohen. From 1996 through 2004, EZCORP entered into a series ofservices agreements with non-party Morgan Schiff, an investment firm founded by Cohen. Under these agreements, EZCORP paid $33,333 per month to Morgan Schiff, which by 2004 had increased to $100,000 per month ($1.2 million annually). After an expense review, EZCORP discovered it had overpaid Morgan Schiff by $400,000. EZCORP recovered the overpayment and elected not to renew its arrangement with Morgan Schiff.

For part of the period covered by the agreements with Morgan Schiff, EZCORP paid a dividend to its stockholders. According to EZCORP's public filings, the Board declared an annual dividend of $0.05 per share in cash, payable quarterly, on August 25, 1998. EZCORP continued making a quarterly dividend payment of $0.0125 per share through March 31, 2000. Since then, EZCORP has not paid any dividends, and the Board has stated consistently that it does not anticipate paying any dividends in the future. Based on the number of shares currently outstanding, an annual dividend of $0.05 per share would cost $2.68 million. As previously noted, an annual dividend of $0.10 per share would cost $5.36 million.

In 2004, shortly after terminating its relationship with Morgan Schiff, EZCORP entered into a services agreement with a different Cohen affiliate, defendant Madison Park. The initial services agreement called for EZCORP to pay Madison Park $100,000 per month ($1.2 million annually) for a period of three years. Beginning in September 2007, when the initial services agreement expired, EZCORP and Madison Park entered into a series of annual services agreements. In the 2007 agreement, Madison Park's monthly fee...

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