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Summaries and analysis of recent Delaware court decisions concerning business-related litigation.
Morris James Blogs
Showing 11 posts from April 2010.
In this unusual case filed by a pro se litigant, the Court extended Revlon duties to when a company issues convertible notes that will change control of the company upon conversion. This is consistent with past indications in other decisions.
Delaware's Superior Court has joined the ranks of courts in other states by creating a "business court" for commercial disputes between companies. The new "court" is technically a division within the existing Delaware Superior Court and has major advantages for resolving business disputes. Among those are:
1. Three very experienced judges have been assigned to cases filed in the new divisions and will stay with those cases until they are completed.
2. Each case will be subject to a tight case management order designed to control litigation expenses and keep the litigation moving to completion.
3. Discovery of electronically stored data will be subject to special "e-discovery' orders that will limit expense and avoid disputes.
4. Protocols are to be adopted for each case to control expert witness discovery and the recovery of inadvertently produced privileged information.
The creation of this new division followed an extensive review of business courts through out the United States by a Special Committee and adopts the best procedures of those other courts. The Delaware Superior Court and the Delaware Court of Chancery have been consistently voted the best courts for business disputes in the United States. For more details, see the Administrative Directive establishing the new division and the Special Committee's report.
This is an interesting appraisal decision for 2 reasons. First, the Court declined to use the price set in the market as a strong indicator of value notwithstanding recent decisions in Delaware that had been inclined to do so. The Court was not satisfied that in the case of this company with its dominant stockholders announcing that they would only support the deal on the table that there was a real market check.
Second, the Court's analysis of how to do a discounted cash flow valuation again illustrates its preference for expert opinion based on a knowledge of the industry involved.
This decision is interesting because it upholds a forum selection clause requiring litigation in England. How these parties could have not chosen Delaware seems unbeliveable.
The opinion also applied the forum selection not just to disputes that were based on the parties' contract, but also to tort claims that arose out of the same facts. In short, you cannot plead around the forum you chose.
This important decision focuses on the increasingly controversial issue of vote buying in stockholder elections. In general, vote buying occurs when a party acquires the right to vote stock it does not have legal title to or hold the beneficial interest in that stock. It just buys the right to vote the stock. On the other hand, when the buyer acquires the economic interests represented by the stock along with the right to vote it, that is not vote buying even if he does not then acquire legal title to the stock. The distinction may be critical as votes acquired by vote buying are invalid.
Exactly how this will play out is not clear. For example, if the buyer obtains the right to vote and all appreciation in the value of the stock, but not title, that seems to satisfy the test and is not vote buying. That is so even if he never has title transfererd to him or, possibly, even if all the buyer's rights revert to the seller a moment after a stockholder election. We shall see.
In this 193 page opinion, the Court imposed a large fee award for the failure to disclose important documents during discovery. The decision is a useful collection of authority on the parties' discovery obligations and the Court's powers to penalize offenders.
This decision clarifies the effect of where an action is first filed. When the case is filed first in Delaware, a Delaware court may only dismiss it on the grounds the forum is inconvenient when the defendant can show it will be an "overwhelming hardship" to litigate it in Delaware.
On the other hand, when an action is first filed in a forum other than Delaware, the general rule is to defer to the other jurisdiction and stay or dismiss the second suit filed in Delaware. While there are numerous exceptions to this general rule, the burden is much less to have the case dismissed.
When a payout in an M&A deal is dependent on post closing events, somehow the former stockholders must be represented if there are to be any adjustments. Appointment of a stockholder representative is often done for that purpose. Here the Court held that the stockholder representative may also sue to enforce the rights of a class of stockholders to such payments.
The Court of Chancery Reaffirms the Vitality of Claims Asserting Insider Trading as a Breach of the Fiduciary Duty of Loyalty
Vice Chancellor Laster recently affirmed the continuing vitality of state law “Brophy” claims for Delaware corporations injured by their fiduciaries’ insider trading. In so ruling, the Court clarified the elements of a Brophy claim, explained why the claim is firmly grounded in the duty of loyalty applicable to Delaware fiduciaries and discussed why such claims complement and do not conflict with the federal securities law regime. Less clear and undecided by the decision are the elements of damage the corporation might recover.
The Toll Brothers decision arose in the context of a motion to dismiss a shareholder derivative complaint brought for the benefit of Toll Brothers Inc. against eight of the eleven directors of the corporation. The complaint alleged they sold significant amounts of their Toll Brothers stock during the period from December 2004 through September 2005. The complaint further alleged that they did so while in possession of material nonpublic information about Toll Brothers’ future prospects that contradicted the Company’s upbeat disclosures about its business prospects and expected growth and earnings. When the Company in December 2005 suddenly revised its public growth forecast for 2006 net income downward from 20% to 0.5%, its stock price precipitously dropped.
A federal securities lawsuit followed joining the individual defendants and alleging they made material misrepresentations and omissions of material fact in connection with projections for 2006 and 2007 that were “knowingly unreasonable” when made. The federal action also alleged insider trading in violations of Section 10(b)(5). The federal court upheld the securities claims against a motion to dismiss under the rigorous standards for pleading securities fraud and the case moved to merits discovery.
The Delaware derivative action followed in November 2008. The Delaware complaint had two counts. The first alleged breach of fiduciary duty under Brophy v. Cities Service, 70 A.2d 5 (Del. Ch. 1949) for harm caused by insider trading. The second count was a generalized claim for indemnification and contribution for harm to the Company resulting from the federal securities fraud action. The director defendants moved to dismiss both counts on various grounds including that Brophy is an outdated precedent that should be rejected.
The Court rejected all of the defendants’ arguments challenging the Brophy claim. The Court first stated the elements of claim: “1) the corporate fiduciary possessed material, nonpublic company information; and 2) the corporate fiduciary used that information improperly by making trades because he was motivated, in whole or in part, by the substance of that information.”
The Court found that the complaint sufficiently pled a reasonable basis from which the fiduciaries’ knowledge could be inferred. The inference was based on specific allegations of the defendants’ knowledge and reliance on core metrics the Company used to measure and forecast growth and earnings, the contrast between the defendants’ public statements and the underlying trends indicated by the Company’s metrics, and the defendants’ contemporaneous massive sale of securities. The Court ruled the allegations supported a pleading stage inference that the Sellers took advantage of confidential corporate information not yet available to the public to unload significant blocks of shares before the market’s views of Toll Brother’s prospects dramatically changed. The Court contrasted this case from those cases dismissed at the pleading stage where evidence of accounting improprieties were disclosed in a subsequent restatement and senior officers and directors sold stock during the period covered by the restatement. Those cases the Court noted lacked allegations supporting an inference that the fiduciaries would have known of the particular accounting problems, in contrast to the core operational information involved in the Toll Brothers case.
The Court also addressed and rejected the assertion that Brophy was an anachronism that predated the current federal insider trading regime and should no longer be followed. Brophy involved a corporate secretary who knew of Cities Service’s planned open market purchases that would likely boost its stock price. The fiduciary bought for his personal account in advance of the corporate purchase and later sold the shares at a profit after the market price rose. Rejecting the argument that the corporation suffered no harm, the Brophy Court said “Public policy will not permit an employee occupying a position of trust and confidence toward his employer to abuse that relation to his own profit, regardless of whether his employer suffers a loss.”
Vice Chancellor Laster in the Toll case explains why the Brophy claim does not duplicate the federal securities laws and does provide a meaningful remedy for corporate harm. First, a Brophy claim does not exist to recover losses by contemporaneous traders, nor does it automatically require disgorgement of reciprocal insider trading gains; rather it is to remedy harm to the corporation. Pointing to Delaware Supreme Court precedent rejecting claims of breach of fiduciary duty or fraud as a basis for the class-wide recovery of trading losses, the Court agreed with Vice Chancellor Strine in his recent AIG opinion upholding a Brophy claim that it is harm to the corporation that is of primary concern. Vice Chancellor Laster wrote that harm in the case of insider trading might include the costs and expense the corporation incurred for regulatory proceedings involving the insider trading, internal investigations, fees paid to counsel and other professionals, fines paid to regulators and judgments in litigation. In this case and the recent AIG case, both of which involved companion securities law litigation naming the corporation a defendant, the Court noted that the defendants’ breaches of the duty of loyalty, involving trading on confidential information and material misrepresentations and omissions, may subject the corporation to a substantial judgment or settlement in the federal securities action.
The Court left to another day the precise type of damages or remedy that would be available if plaintiff proved its case. It noted, however, that Delaware remedies to protect the corporation and non-duplicative of the federal remedies that might be granted, were necessary and available to remedy breaches of the fiduciary duty of loyalty based on insider trading. Avoiding damages duplicative of the federal securities laws and satisfying public policy concerns regarding indemnification for securities fraud violations remain significant issues in fashioning a damage award for successful derivative plaintiffs. See e.g., Richard A. Booth, The Missing Link Between Insider Trading and Securities Fraud, 2 J. Bus. & Tech. L. 185-206 (2007).
The Court’s opinion also dealt quickly with defendants’ arguments that the derivative complaint failed to plead demand futility adequately under Rule 23.1 and was barred by the statute of limitations. Using the Rales standard, the Court concluded that demand was excused because a majority of the Board could not consider the merits of a demand without being influenced by improper considerations. Because of the potential personal liability a majority of the directors faced in the federal securities action, they faced a sufficiently substantial threat of personal liability to compromise their ability to act impartially on a demand.
As to the statute of limitations, the Court acknowledged that the complaint was filed more than 3 years after the alleged insider trading, but it found the pleading supported a basis for equitable tolling. Because the complaint alleged wrongful self-dealing and shareholders’ reasonable reliance on the competence and good faith of the director fiduciaries until December 2005 when management officially abandoned its previous growth projections, the Court ruled the running of the limitations period was equitably tolled until then.
Finally, the Court acknowledged the tension between allowing the concurrent prosecution of the shareholder derivative action for the benefit of the corporation at the same time the corporation seeks to defend itself from liability in the federal securities action. Not wanting to have the derivative action burden the corporation’s ability to defend itself in the securities action, the Court urged the parties to coordinate the actions and acknowledged the possibility of a stay of the derivative action pending the outcome of the securities action as was done in the AIG case.
In a rare split amongst the Justices, the Delaware Supreme Court has divided over when the duty of good faith and fair dealing applies. The majority opinion is an example of the views of Chief Justice Steele who is noted for his stance that a contract should be held to fix the parties' rights and there is little room to add to those rights under the so-called duty to act in good faith and with fair dealing. If the circumstances that the plaintiff complains of might have been anticipated when the contract was drafted, it is too bad if the contract does not give the plaintiff what he now wants.
The two Justices in the minority, Justices Jacobs and Berger, are not so sure they want to rely entirely on what the parties put into their contract to define their rights in all circumstances. They are more inclined to expand a party's rights when they feel the other side has acted in a way that would not have been agreed to had they thought about it beforehand.
For now at least, the strict upholding of the contracts limits has won the day.