Delaware jurisprudence encourages decision-making by boards of independent and disinterested directors. If a transaction does not involve a controlling stockholder and is approved by a majority of disinterested and independent directors, then a plaintiff cannot attack the transaction and seek damages except upon pleading that a majority of the board acted in bad faith.
As illustrated by the recent decision in Kahn v. Stern, C.A. No. 12498-VCG (Del. Ch. Aug. 28), this standard is difficult to meet. Invoking a metaphor from a Tennyson poem, Vice Chancellor Sam Glasscock held that the plaintiff had failed to plead facts demonstrating an entitlement to relief and hence to discovery and dismissed plaintiff's challenge to a cash-out merger. The case provides guidance on the need for well-pleaded facts at the pleading stage to establish a reasonably conceivable basis to conclude that a majority of directors is not disinterested and independent or that a board acted in bad faith.
The plaintiff held stock in Kreisler Manufacturing Corp., a family-owned aerospace company that traded in the pink sheets. Following a sale process in which dozens of potential acquirers participated, the receipt of a fairness opinion and a recommendation of a special committee, the company's board approved a merger at $18 per share with the high bidder, Arlington Capital Partners (the buyer). While the buyer was negotiating the terms of its initial bid of $18.75 "subject to adjustments," two management directors negotiated side deals. In one the CEO and co-president secured employment as the president of the post-merger entity and a rollover of his equity into one of the buyer's subsidiaries; in the other the CEO's brother, co-president and COO, negotiated for better terms in his employment agreement upon his desired termination after the merger. Both also negotiated for a sale bonus agreement that would pay them up to $105,000 (or roughly 38 percent more than their annual salaries) upon consummation of the merger. The merger was approved by the written stockholder consents of two of the management directors, two of the remaining three directors, and an independent investor totaling approximately 53 percent of the issued and outstanding shares.
Following receipt of the information statement, the plaintiff brought this class action alleging the approval of the side deals and misstatements and omissions in the information statement provided to stockholders reflected bad faith.
Court Rejects Plaintiff's Allegation
Of the company's five-person board, two directors were interested and two were concededly disinterested and independent. The fifth director owned approximately 19 percent of the company's common stock, had aligned with an activist investor who previously had favored a sale, and had been excluded from the special committee formed to consider the merger. The court found these allegations insufficient. The fact that he owned a large block of illiquid shares was not sufficient without allegations that he received different or unique consideration or that he faced an exigent need to sell. And the conclusory allegation that he was not put on the special committee did not suffice standing alone to raise a reasonable doubt as to his independence. The court found that these allegations failed to raise a reasonable doubt as to his independence and that his being the largest single stockholder allied him with the common stockholders in being incentivized to seek the highest price. The court therefore held that a majority of disinterested and independent directors approved the merger.
Approval of Side Deals and Disclosure Allegations Insufficient
While acknowledging that a pleading of board approval of side deals that are so egregious and one-sided as to be inexplicable on grounds other than bad faith would suffice to state a claim, the court found the allegations here failed to rise to that level. The court found most problematic the amended employment agreement, which provided "better benefits" to a retiring officer and director. Unlike the side bonus agreement, which the court found served a rational purpose to incentivizing management before and after the merger, the amended employment agreement for the retiring officer and director could not be said to do the same. The deficiency in the plaintiff's pleading was the failure to allege the materiality of the "better benefits" to the officer in question. The court held that the allegations were insufficient to allow him to infer "that the benefits were unearned, material in light of the merger consideration, or otherwise were 'so far beyond the bounds of reasonable judgment that it seems essentially inexplicable on any ground other than bad faith'" Similarly, the court found that the plaintiff's allegations that the information statement omitted or misstated facts about the financial circumstances of the company or the projections relied upon by the financial adviser or the business purpose of the Side Deals failed to create "an inference that the Defendants deliberately withheld the information or disregarded a manifest duty."
This case illustrates the difficulty of pleading a claim for damages post-closing of a merger transaction not involving a majority stockholder. Unless a plaintiff can plead that a majority of the board that approved the transaction was not disinterested and independent, then the plaintiff cannot state a claim unless the plaintiff can plead in a nonconclusory fashion that the disinterested and independent majority of the board either acted to approve a transaction that was so manifestly unfair that no reasonable director could have done so or intentionally to misstate or omit material information from stockholders so as to reflect bad faith. The court found that the plaintiff had failed to meet that pleading standard here, even as it acknowledged that, had the plaintiff so moved, some of the disclosure allegations may have sufficed to warrant injunctive relief under an enhanced scrutiny standard where motive was not at issue. The defendants did disclose in detail the side bonus agreement and the amendments to the employment agreements. The case thus is another affirmation that boards with disinterested and independent majorities who fully disclose the material facts will not face personal liability in damages unless the plaintiff can meet a high pleading standard and assert egregious facts that would support an inference of bad faith by a majority of the board.