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Summaries and analysis of recent Delaware court decisions concerning business-related litigation.
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This interesting decision explains the status of a de facto director and what that means in terms of the validity of actions taken by such directors. In general, their actions are valid. The decision is also another illustration of the duties owed by a board of a charity to its beneficiaries.
This decision affirms the standing of someone not yet elected to the board to seek relief under Section 225.
When may most of a Board of Directors deny another director access to the advice of counsel the majority received? This decision answers that interesting question and concludes "not very often." There are exceptions to that general rule, such as when there is a board committee involved whose counsel has not also been counsel to the excluded director, when the excluded director wants the information for a proven improper purpose, etc.
A Section 225 action is supposed to be limited to the narrow question of the composition of a corporation's board of directors. Subsidiary questions, such as who owns what stock, may be resolved as well but are generally not binding on persons who are not parties to the litigation. However, as this decision points out, if you are a party and consent to the Court deciding stock ownership in a Section 225 action, you are stuck with the judgment.
Everyone agrees that a director should speak up even if he disagrees with the rest of the board of directors. But when does a director go too far in his opposition to policies he wants to change? In this decision, the Court wrestled with this question and decided that leaking confidential corporate information to pressure the company went too far. Significantly, the information was not about any wrongdoing. Hence, the finding of a breach of the duty of loyalty only goes so far as a precedent.
A year or so ago, the DGCL was amended to permit the removal of a director by the Court of Chancery. While the grounds to do are broadly stated (including "breach of the duty of loyalty"), the statute requires that the director first have been convicted of a felony or been found in a prior case to have breached his duty of loyalty. There thus remains the question of whether director removal may be done without a prior action that establishes the grounds to do so.
This decision suggests that such a direct action for removal will be very hard to win, for the Court expressed serious concerns over whether it has that authority absent the statutory prerequisites. The question is still open to be squarely decided in another case.
This article was original published in The Delaware Business Court Insider | 2011-07-06
On May 31, Vice Chancellor Leo E. Strine Jr. issued an opinion denying a motion for preliminary injunction to halt a merger between Massey Energy Company and an affiliate of Alpha Natural Resources Inc. One of the critical issues in the opinion was the value of the derivative claims Massey had against certain current and former directors and officers arising out of Massey's compliance with federal mining safety regulations.
Massey's attitude toward federal mining safety regulations arguably manifested itself in the Upper Big Branch mine disaster, which resulted in the loss of 29 lives. In his opinion, Strine found that the plaintiffs had probably stated a Caremark claim against the directors of Massey and criticized the board of Massey for failing to assess the value of the derivative claims but ultimately refused to enjoin the merger, concluding that the derivative claims did not have the value plaintiffs believed.
While this result has received some negative commentary, is it really a surprise? In fact, the court's analysis is consistent with prior analyses addressing the value of derivative claims in the context of a merger. The fact that the party here is more infamous than many others did not change the analysis under Delaware law.
The plaintiffs valued the derivative claims based on the "aggregate negative financial effect on Massey that the Upper Big Branch Disaster and its Fall-Out has caused." According to the plaintiffs' expert, these damages range from at least $900 million to $1.4 billion. The court, however, rejected this theory, in large part because the computation of the value of the derivative claims was far more complicated than the plaintiffs' theory.
First, even though the plaintiffs had stated a viable Caremark claim against the directors, because of the business judgment rule and the exculpatory provisions in Massey's certificate of incorporation, in order to obtain a monetary judgment against the directors, they would have to prove that the directors acted with scienter — a difficult standard to meet, particularly with independent directors.
Second, the court also found that even as to the autocratic former leader of Massey, Don Blankenship, who was arguably responsible for Massey's approach to mining safety, meeting this standard would be difficult. The court noted that there is a large gap between pushing the limits of federal regulations while accepting minimal loss of life and knowingly endangering the mine itself by putting its very operations at risk. Moreover, Blankenship was not directly in charge of any specific mine, and tying his policies directly to any disaster would be challenging.
Third, proving that the directors acted with scienter may entitle the corporation to a monetary judgment from the directors, but it would simultaneously expose the company to third-party civil liability and potential criminal liability, and potentially deprive the directors of the ability to rely on insurance coverage, all of which would harm the company.
Fourth, after the merger, Alpha will continue to have to address direct claims against Massey from its lost and injured miners, regulatory consequences of the company's mining safety approach, and other elements of the "Disaster Fall-Out." To the extent possible, Alpha will have every incentive to shift that liability to the former directors.
Fifth, it is impossible to determine the potential derivative liability of the directors until Massey's direct liability is determined. Indeed, it is not even in the interest of Massey's stockholders to press their claims of derivative liability now, before third-party civil and criminal adjudication, lest the plaintiffs expose the company to additional liability.
Sixth, the plaintiffs' expert put no value on the ability of the company or its stockholders to collect on a potential $1 billion judgment. The company's insurance policy, even assuming it is available to cover claims against the former directors, is only $95 million. While this is no small amount, it is, as the court put it, "not material in the context of an $8.5 billion merger."
While the vice chancellor was quick to note that the Massey board's approach to valuation of the derivative claims was less than ideal, because of the factors noted above, he found that the plaintiffs had not persuaded him that the merger was unfairly priced because of the failure to value separately the derivative claims. Was this conclusion so unprecedented, however, to justify criticism of the valuation?
Delaware courts previously have been asked to consider the value of unliquidated, contingent claims belonging to the company in the valuation context. These courts have never valued derivative claims at the full value of all potential damages, but instead have considered many of the factors Strine addressed in Massey.
For instance, in Onti Inc. v. Integra Bank Inc., petitioners in an appraisal action argued that their derivative claims should have been valued as an asset of the company in the appraisal proceeding. The stockholders' expert valued the claims at more than $19 million, while the company's expert valued the claims at negative $2.5 million. The court determined that the claims had no value. In reaching that conclusion, the court adopted the theory advanced by the company's expert, that all litigation factors should be considered, including the likelihood of success on the merits, the attorney fees necessary to obtain that result and any indemnification that the company would owe to its directors. Citing to prior precedent, the court noted that "there would be strong logic in including the net settlement value of such claims as an asset of the corporation for appraisal purposes."
Later that same year, the court took a similar approach in Bomarko Inc. v. International Telecharge Inc. The court valued the claim in that case by multiplying the probability of success by the likely amount of recovery while subtracting costs incurred to obtain that result.
More recently, in Arkansas Teacher Retirement System v. Caiafa, the Court of Chancery overruled an objection to a settlement that released claims that the board failed to ascribe any value to federal derivative claims in a merger. After noting that there is no case law supporting the proposition that the board was required to undertake a separate and discrete valuation of the derivative claims pending at the time of the challenged merger, the court reached the same result as Strine did in Massey, albeit with less analysis. That is, the court noted that the claims asserted in the federal action were difficult to win, and even those that had a higher probability of success could not have the $2 billion value the objectors claimed they did. On appeal, the Delaware Supreme Court affirmed the Court of Chancery's decision to overrule the objection for the reasons set forth in the Court of Chancery's opinion.
Given these precedents, is the result in Massey all that surprising? While some contingent claims have been given value, it is the exception, and not the rule, to assign material value to contingent derivative claims. Moreover, in the context of a merger worth billions of dollars, the likelihood is low that derivative claims have material value, particularly when reasonable defenses can be interposed.
But does this decision mean that boards can just eschew any analysis of the value of a derivative claim in the context of a merger? Probably not. The Court of Chancery certainly did not condone the practice, and had the court not been persuaded that the board otherwise acted properly, the failure to do so could have had more importance.
Further, because the exception to the derivative standing rule that entering into a merger for the purpose of extinguishing derivative claims remains viable, particularly in light of the Supreme Court's opinion in Caiafa, failure to value the claims could support the conclusion that a merger was negotiated simply to avoid liability. Finally, not all derivative claims are equal in this context. As Strine noted in Massey, if Massey had a liquidated claim against a former fiduciary reduced to a judgment but failed to get any value for this claim, he could see the substantial unfairness in failing to obtain value for that claim in a merger. Alternatively, if recovery on any derivative claim after a cash-out merger would inure solely to the benefit of the acquirer, then perhaps there would be value to the buyer in obtaining that claim.
Put simply, as with many issues of fiduciary law, the context of the situation is important. What is fairly clear, however, is that unliquidated contingent derivative claims are not ascribed much value, if any, in a merger context, unless a party can demonstrate a reasonable likelihood that the net value of the claim to the company is material.
Peter B. Ladig (email@example.com) is a partner at Morris James in Wilmington and a member of its corporate and fiduciary litigation group. He represents both stockholders and directors in corporate litigation. The majority of his practice is in the Delaware Court of Chancery, although he has extensive experience in the other state and federal courts in Delaware and has been involved in over 50 published decisions. The views expressed herein are his alone and do not necessarily reflect the firm or any of the firm's clients.
Lewis H. Lazarus
This article was originally published in the Delaware Business Court Insider | June 15, 2011
A plaintiff who pleads successfully that a transaction under attack is governed by the entire fairness standard of review instead of business judgment generally stands a good chance of defeating the defendant's motion to dismiss. That is because when a transaction is reviewed for entire fairness, defendants bear the burden in the first instance of proving at trial the fairness of the process and price.
In two recent cases - Ravenswood Investment Co. v. Winmill and Monroe County Employees' Retirement System v. Carlson - the Court of Chancery clarifies that a plaintiff must still make well-pleaded allegations that a transaction is unfair as to process and price if its complaint is to survive dismissal at the pleadings stage.
Ravenswood involved claims that defendant directors' adoption of a performance equity plan violated fiduciary duties by seeking to dilute the minority stockholders' percentage interest in non-voting Class A shares (only Class B shares had voting rights). The court noted that the entire fairness standard applied because "where the individuals comprising the board and the company's management are the same, the board bears the burden of proving that the salary and bonuses they pay themselves as officers are entirely fair to the company unless the board employs an independent compensation committee or submits the compensation plan to shareholders for approval."
Because the directors employed no such protective measures, the court held that the entire fairness standard of review applied. Still, citing Monroe County, the court held that the plaintiff "bears the burden of alleging facts that suggest the absence of fairness."
The court dismissed the plaintiff's complaint because it found he had failed to make well-pleaded allegations that the defendant directors' adoption of the performance equity plan was unfair. Critical to the court's reasoning was that dilution occurs upon the adoption of any options plan; the question is whether the manner in which the options were issued unfairly diluted the stockholders.
As the defendants in their motion to dismiss did not challenge the plaintiff's claim for unfair issuance of the options, the court found that the plaintiff's allegation of dilution did not suffice to state a claim for unfairness in the adoption of the performance equity plan.
This was so because the plaintiff alleged that "(1) the Performance Equity Plan only authorizes the Board to grant stock options with an exercise price not lower than the market value as of that event, (2) the Defendants already control all of the Company's voting rights through their ownership of its Class B shares, and (3) even if all options authorized under the plan were to be granted to the Defendants they would not obtain a majority interest in the Class A shares... ."
The court noted that although it was true that the Class A shares could vote to approve a merger, the plaintiff made no allegation in his complaint that the adoption of the performance equity plan impaired those voting rights. The court declined to comment on whether such an allegation may have sufficed to sustain this claim.
The Ravenswood court relied upon the court's holding in Monroe County. That case involved a challenge to an intercompany agreement that required the plaintiff's company to purchase services and equipment from its controlling shareholder on terms in conformity with (for services) or the same as (for equipment) what the controlling shareholder charged its other affiliates. The parties agreed that the arrangement the plaintiff attacked was governed by the entire fairness standard of review.
They disagreed as to whether the plaintiff's pleading sufficed to survive a motion to dismiss.
As summarized by the court: "Delaware law is clear that even where a transaction between the controlling shareholder and the company is involved such that entire fairness review is in play, plaintiff must make factual allegations about the transaction in the complaint that demonstrate the absence of fairness. (citations omitted). Simply put, a plaintiff who fails to do this has not stated a claim. Transactions between a controlling shareholder and the company are not per se invalid under Delaware law. (citation omitted). Such transactions are perfectly acceptable if they are entirely fair, and so plaintiff must allege facts that demonstrate a lack of fairness."
In reviewing the complaint, the court found no allegations that the price at which the controlling stockholder provided the services and equipment was unfair. Instead, the court found that plaintiff's allegations addressed only alleged unfair dealing.
In the absence of an allegation that the company could have obtained the services or equipment on better terms from a third party or any specific allegation of the worth of the services or equipment relative to what the company paid, the court found that the complaint did not make sufficient factual allegations that the intercompany agreement transactions were unfair. Because the plaintiff chose to stand on its complaint in response to the defendants' motions to dismiss rather than to amend, the court dismissed plaintiff's complaint with prejudice under Court of Chancery Rule 15(aaa).
Together, these two cases clarify that a plaintiff cannot survive a motion to dismiss simply by alleging that a transaction involving a controlling stockholder is unfair. A plaintiff instead must make particular factual allegations suggesting why the transaction was unfair. A plaintiff who cannot make such allegations and who stands on a conclusory complaint, as in Ravenswood, may find that its claims are dismissed with prejudice.
Lewis H. Lazarus (firstname.lastname@example.org) is a partner at Morris James in Wilmington and a member of its corporate and fiduciary litigation group. His practice is primarily in the Delaware Court of Chancery in disputes, often expedited, involving managers and stakeholders of Delaware business organizations. The views expressed herein are his alone and do not necessarily reflect the firm or any of the firm's clients.
The Delaware Supreme Court has held that when there are staggered terms for the members of a board of directors that the annual stockholders meetings must be about 1 year apart. In this case, the next board meeting was set for June, 2011 or 6 months after the last meeting. The Court held that was acceptable because the directors whose terms would expire at the new board meeting were elected 3 years ago. Of course that left open whether continuing the new meeting date in 2012 might cut short the tems of other directors. The Court declined to resolve that issue until the next meeting date was actually set.
Chancery Decisions Highlight Importance of Independent and Disinterested Directors in Company Sale Transactions
Lewis H. Lazarus
This article was originally published in the Delaware Business Court Insider | May 25, 2011
Two recent decisions from the Court of Chancery — In re Orchid Cellmark Inc. Shareholders Litigation and In re Answers Corp. Shareholders Litigation — illustrate how parties may reduce deal risk by ensuring that the directors responsible for managing a sale process are disinterested and independent. At the same time, while the court in both cases rejected challenges to the transactions based on allegedly excessive deal protection terms, the court also signaled that providing much more than the parties did in Orchid may break the court’s proverbial back.
Independence and Disinterest
The court decided each of these cases following an expedited preliminary injunction hearing at which the plaintiffs sought to enjoin the transactions based in part on an allegedly inadequate sales process. In this Revlon Inc. v. MacAndrews & Forbes Holdings Inc. context, the court is called upon "to assess carefully the adequacy of the sales process employed by a board of directors." A primary inquiry in assessing a transaction is whether the directors responsible for the negotiations are independent and disinterested.
In Orchid, the court noted that five out of the six directors were independent. Its board formed a special committee to negotiate the transaction. That committee included two independent directors and a third newly elected director who had been nominated by the company’s largest shareholder. In addition to the independence of the special committee, the court also found no reason to doubt the independence or credentials of the special committee’s financial adviser.
Likewise, in Answers, although the plaintiffs raised questions about the independence of two of the directors, the court found that those directors did not lead the negotiations. Moreover, four out of the seven directors who approved the transaction were disinterested and independent. Finally, the court held that the company’s financial adviser’s independence and qualifications were not seriously challenged. The independence of the directors and their advisers were significant factors in the court’s decision in both cases to uphold the reasonableness of the boards’ decision making.
Deal Protection Terms
The court noted that deal protection terms such as termination fees, expense reimbursements, and no-talk and no solicitation clauses are standard. The issue is whether cumulatively they are impermissibly coercive or preclusive of alternative transactions. In Answers, the court observed that the break-up fee of 4.4 percent of equity value was at the upper end of the "conventionally accepted" range.
However, the court stated that this is not atypical in a smaller transaction. The court also rejected the plaintiffs’ challenge that the court should measure the break-up fee in reference to enterprise value on the ground that "Our law has evolved by relating the break-up fee to equity value."
In Orchid, the parties' deal protection included not only standard no-shop and termination provisions, but also a top-up option, matching rights and an agreement to pull the company’s poison pill, but only as to the buyer. The court held that top-up options are standard in two-step tender offer deals. As to the termination fee, the court found it appropriate in reference to the equity value of the target and again rejected the plaintiffs' effort to measure the termination fee in reference to enterprise value. The court also recognized that the matching and informational rights might have a deterrent effect on a hypothetical bidder, but it found those provided in the merger documents would not preclude a serious bidder from stepping forward.
The court also found that the selective pulling of the pill was not impermissibly preclusive of alternative bids. The court reasoned that the merger agreement enables the board to redeem the pill if it terminates the merger agreement. Termination is permitted if the board receives a superior offer and withdraws its recommendation that the stockholders tender their shares. The court observed that the termination fee that would be owed if the board terminates the merger agreement for a bidder who makes a superior offer and then pulls the pill would be no greater than if the company accepts a superior offer or terminates the merger agreement for some other reason.
Finally, because "a sophisticated and serious bidder would understand that the board would likely eventually be required by Delaware law to pull the pill in response to a Superior Offer," the court ruled that the deterrent effect of these provisions likely was minimal.
In so holding, the court stated that deal protection measures evolve and cautioned that at some point incremental protection may prove too much:
"Deal protection measures evolve. Not surprisingly, we do not have a bright line test to help us all understand when too much is recognized as too much. Moreover, it is not merely a matter of measuring one deal protection device; one must address the sum of all devices. Because of that, one of these days some judge is going to say 'no more' and when the drafting lawyer looks back, she will be challenged to figure out how or why the incremental change mattered. It will be yet another instance of the straw and the poor camel's back. At some point, aggressive deal protection devices — amalgamated as they are — run the risk of being deemed so burdensome and costly as to render the 'fiduciary out' illusory."
Together, these two cases demonstrate the value of a disinterested and independent decision-making body running a sale process. Also, while the court rejected claims that the deal protection at issue was preclusive or coercive, the court also cautioned that counsel must be careful not to make an alternative transaction too burdensome or costly, lest any fiduciary out be deemed illusory. Counsel should carefully evaluate the context of each transaction in determining appropriate deal protection, lest an added straw of protection is found to be the one that breaks the court’s proverbial back.
Lewis H. Lazarus (email@example.com) is a partner at Morris James in Wilmington and a member of its corporate and fiduciary litigation group. His practice is primarily in the Delaware Court of Chancery in disputes, often expedited, involving managers and stakeholders of Delaware business organizations. The views expressed herein are his alone and not those of his firm or any of the firm's clients.
Directors Designated By Investors Owe Fiduciary Duties to the Company as a Whole and Not to the Designating Investor
This article was originally published in The Delaware Business Court Insider | 2011-03-23
Investors who make substantial investments often demand a seat on their company’s board of directors. That is a reasonable request as it permits the investor to have a representative on the board of directors with a voice in management of the company. It is well-settled that directors elected by stockholders of a Delaware corporation owe fiduciary duties to the company and all its stockholders once they serve on the board. Thus, they may make decisions in the exercise of their fiduciary duty that are different than what is in the best interest of designating investor. The Court of Chancery’s recent decision in Air Products and Chemicals, Inc. v. Airgas, Inc., 2011 WL 519735 (Del. Ch. Feb. 15, 2011) reflects this issue.
Air Products had sought to acquire control of Airgas since October, 2009. When Airgas rebuffed its inquiries, Air Products launched a hostile tender offer. One of the conditions of its tender offer was that Airgas lift its poison pill. The poison pill made it prohibitively expensive for Air Products to proceed. Airgas refused to lift the pill on the ground that the Air Products offer was inadequate.
Frustrated by its inability to proceed with a tender offer, Air Products nominated three directors to the Airgas board. It stated that its nominees would be impartial in their evaluation of the Air Products tender offer, although they would be replacing Airgas directors who had voted to maintain the Airgas poison pill. Air Products succeeded and its three nominees were elected by the Airgas stockholders to the Airgas board. Once they were on the board of Airgas, the Air Products designees obtained their own legal and financial advisors. Based in part on the advice of their advisors and on their own assessment of the business plans of Airgas, these Air Products nominated directors determined that the Air Products offer was inadequate and voted with their colleagues to maintain the Airgas poison pill.
In so acting, these directors acted consistently with Delaware law. As stated in Phillips v. Insituform of N. Am., Inc., 1987 WL 16285, at *10 (Del. Ch. Aug. 27, 1987) the “law demands of directors … fidelity to the corporation and all of its shareholders and does not recognize a special duty on the part of directors elected by a special class to the class electing them.”
While the Airgas directors’ conflict arose in a highly-publicized battle for control of a public company, issues also arise in privately held companies where investors often condition their investment on the receipt of preferred stock and board representation.
For example, in In re Trados Incorporated Shareholder Litigation, 2009 WL 2225958 (Del. Ch. July 24, 2009), the Court of Chancery sustained a complaint on behalf of a class of stockholders who complained that directors designated by preferred stockholders, constituting a majority of the board, had interests that diverged from the interests of the common stockholders in approving a sale transaction. This divergence arose because the preferred stockholders received a substantial portion of their liquidation preference from the sale, while common stockholders received nothing. The preferred stockholder designated directors also held interests in entities which held preferred stock of the selling company. Those relationships bore on the court’s decision to treat the preferred stock designees as having interests potentially different from, and in conflict with, the interests of the common stockholders. As a result of this finding, the court denied a motion to dismiss because the plaintiffs’ allegations were sufficient to rebut the presumption of the business judgment rule.
These cases teach that directors designated by particular stockholders or investors owe duties generally to the company and all of its stockholders. Where the interests of the investor and the company and its common stockholders potentially diverge, the directors cannot favor the interests of the investor over those of the company and its common stockholders.
Conflicts also are likely to arise over the use of confidential information supplied to the designated directors. Designating directors who owe their livelihood or materially benefit from relationships with the designating investor sharpens the likelihood of conflicts of interest. Companies, investors and directors and their counsel should consider carefully the implications of directors designated by particular stockholders serving on boards of Delaware corporations.
Determining if a claim is direct or derivative is often difficult. Here the Court explains that a claim asserting the directors are acting outside their authority in violation of the relationship set out in Section 141 of the Corporation Code is direct. The facts of this case are unusual as it involves a stockholder agreement whose apparent violation is at the center of the decision.
This decision holds that the Unifrom Contribution Among Joint Tortfeasors Act applies to claims against directors. While at least 1 other court agreed with this point, this is the first Delaware decision on this issue.
This is important becaue it has serious implications to settlements with some but not all directors in derivative and class claims and as it may give leverage to former directors who are now on the outs.
This significant decision holds that you cannot eliminate a director by amending the bylaws to reduce the number of seats on the board of directors. Of course, this only came up in the odd context of a stockholder who could not vote for directors and hence could not vote to eliminate them as well. Nonetheless, it is interesting as a limit on the power to amend bylaws
Perhaps more importantly, the decision explains the complicated and often misunderstood ways in which proxies are obtained to vote the shares of public companies. Those shares are mostly held in the name of Cede & Co., a depository for brokers and banks. Getting the proxy from Cede, and then to the brokers and then to the actual beneficial owners has proved cumbersome in fast proxy battles. This decision helps that process by letting the records of Cede act as a list of owners.
This is the first Delaware decision to deal with the so-called Pfizer policy on when directors may be retained despite a shareholder vote on dissatisfaction. Axcelis had a bylaw that any director up for re-election who did not get a majority of the votes cast must tender her resignation to a committee of the whole Board, and that committee had the discretion to accept or reject the resignation. When three directors did not get the majority vote and tendered their resignations, the committee rejected the resignations and the directors stayed on the Board. The plaintiff then filed a books and records case to discover why.
The Court held that under the company policy the committee had the discretion to reject the resignations. In the absence of even a minimal showing that the exercise of discretion was wrongful, the Court denied inspection into the committee's reasoning. That seems consistent with existing Delaware law. Otherwise, any stockholder who disliked a board decision might demand inspection of corporate records to fish for a basis to sue.
The implications of this opinion are that any committee who rejects a director resignation under a policy giving it broad discretion will have its decision upheld. Indeed, the decision is virtually unreviewable.