33rd Annual Distinguished Lecture in Law

The Delaware Journal of Corporate Law of Widener University Delaware Law School

presents the 33rd Annual Francis G. Pileggi Distinguished Lecture in Law

Is Delaware Retreating?

Randall S.Thomas
John S. Beasley II Chair in Law and Business
Director, Law & Business Program
Professor of Management, Owen Graduate School of Management
Vanderbilt Law School

Friday, October 20, 2017

8:00 a.m. Breakfast; 8:45 a.m. Lecture

Hotel DuPont, du Barry Room
11th and Market Streets
Wilmington, Delaware 19801

Encore presentation 11 a.m.

Widener University Delaware Law School

One substantive CLE credit available in DE and PA

Register online here.

For additional information or for accessibility and special needs requests,
contact Carol Perrupato at caperrupato@widener.edu or 302-477-2178.

Prior Annual Pileggi Distinguished Lectures have been highlighted on these pages. This Lecture Series was funded by my late father, F.G. Pileggi, Esq., over 30 years ago when I was on the law review and was thinking of a vehicle to attract prominent scholars to contribute law review articles, based on their annual lectures.

Chancery Finds Breach of Obligation to Use “Diligent Efforts”

A recent Delaware Court of Chancery opinion is useful for commercial litigators who encounter the frequent situation where one party is required to use some variation on the standard of “best efforts” to either sell a product or reach certain revenue milestones, for example, in connection with a joint venture or a post-closing earn-out. In BTG International, Inc. v. Wellstat Therapeutics Corporation, C.A. No. 12562-VCL (Del. Ch. Sept. 19, 2017), the court applied the contractually defined standard of “diligent efforts” to the promotion of a pharmaceutical product, in a post-trial opinion.  This discussion of the contractually defined standard of diligent efforts is at least generally analogous to other cases highlighted on these pages that address the standard of “reasonable best efforts” or “commercially best efforts” or the like, to perform certain tasks or to reach certain goals.  Due to the relative paucity of cases thoroughly analyzing these types of standards, this case will likely be useful to many readers.

Background: This case involved a distribution agreement between two pharmaceutical companies. BTG was the larger company and agreed to promote, distribute and sell a drug called Vistogard, that the smaller Wellstat did not have the resources to promote, distribute and sell.  After extensive negotiations, the parties agreed to a contractual definition of “diligent efforts” which BTG was required to employ in order to reach various sales goals for Vistogard.  In addition, the parties were required to work together to formulate and finalize a business plan that would describe the details for promoting, distributing and selling Vistogard.

Key Findings: The court found that BTG failed to hire a sufficient number of sales representatives and failed to devote other resources to sell Vistogard, but instead focused most of its efforts and resources on a completely different product in a different division of the company – – with instructions from the CEO to keep the costs flat related to Vistogard and not to increase the resources that were necessary to implement the business plan.

The court found that BTG failed to comply with the contractually defined standard of “diligent efforts” and also breached the agreement by not complying with the business plan that required certain resources, including a sufficient number of sales representatives, to be devoted to the sale of Vistogard.

Legal Analysis: The court provides a useful discussion of the elements of a claim for breach of contract and for awarding damages. The court also took the rare step of shifting fees due to bad faith litigation tactics, and explained its reason for doing so.

The court recited the familiar elements for breach of contract: (1) the existence of a contract, whether expressed or implied; (2) the breach of an obligation imposed by that contract; and (3) the resultant damage to the plaintiff.

BTG took the aggressive approach of filing a declaratory judgment action seeking a declaration that it had not breached the contract. In response, Wellstat asserted a counterclaim for breach of contract. In sum, the court treated the DJ action as a defensive tactic, which failed, in part because Wellstat did not breach the agreement such that it would have excused a performance of BTG.

This 60-page decision provides extensive detailed factual background which is necessary to fully appreciate the court’s thorough analysis. For purposes of this relatively short overview however, the key points in the analysis are based on the court’s finding that BTG failed to devote the necessary resources for Vistogard – – and instead prioritized the sale and promotion of other products of BTG other than Vistogard.  In addition to failing to comply with the contractual definition of diligent efforts, BTG also breached the agreement by failing to comply with the business plan that required a minimum amount of resources to be devoted to the sale and promotion of Vistogard.

The court also discussed principles applicable to claims for breach of contract damages. The basic remedy for breach of contract should give the non-breaching party “the benefit of its bargain by putting the party in the position it would have been but for the breach.” See footnote 170.  Expectation damages require the breaching party to compensate for the reasonable expectation of the value of the breached contract.  These damages are to be measured “as of the time of the breach.” See footnote 172.

Although expectation damages should not act as a windfall, the “injured party need not establish the amount of damages with precise certainty when a wrong has been proven and injury established. Doubts about the extent of damages are generally resolved against the breaching party.” See footnotes 173 through 175.

Moreover the court noted that: “Public policy has led Delaware courts to show a general willingness to make a wrongdoer bear the risk of uncertainty of a damages calculation where the calculation cannot be mathematically proven.” See footnote 175.

The court concluded by taking the unusual step of shifting fees due to bad faith litigation conduct, which included the need during the litigation for Wellstat to file a motion to compel before BTG complied with its discovery obligations, as well as BTG presenting a misleading demonstrative exhibit at trial. See footnotes 216 through 218.

Chancery Rules on Stock Transfer Restrictions

In my latest column for the National Association of Corporate Directors’ publication called Directorship, I provide an overview of a recent opinion from the Delaware Court of Chancery which examined the nuances of stock transfer restrictions. I previously highlighted the decision in Henry v. Phixios Holdings, Inc. on these pages.

Chancery Refuses to Seal Courtroom for Allegedly Confidential Trial Exhibits

The Court of Chancery recently rejected a request by a non-party to seal certain trial exhibits so that they would not become part of the public trial record.  The court also rejected a request to close the courtroom to the public during trial for any testimony or argument regarding those exhibits.  ADT Holdings, Inc. v. Harris, C.A. No. 2017-03218-JTL (Del. Ch. Sept. 28, 2017).

Court’s Reasoning: The court explained that Court of Chancery Rule 5.1, which provides for designating certain filings with the court as confidential if various criteria are satisfied, reflects a commitment of the court to maintaining public access to its proceedings–with limited exceptions. The opinion provided copious citations to various authorities supporting the well-settled presumption that court proceedings are open to the public, based on multiple public policy reasons.

The court reviewed the documents that the movant requested confidential treatment for, and found that they were in large measure “form” documents, as opposed to customized documents, that did not contain any information that would disadvantage the moving party in its future negotiations.  The court was not convinced that any of the documents contained information that would create a risk of economic disadvantage with respect to competitors and others in the industry.

In essence, the court found that the allegations of harm from public disclosure were conclusory and not sufficiently buttressed by details or convincing facts.

For example, the court reasoned that there was no credible basis to believe that the arm’s-length relationship between the persons seeking confidential treatment and the other parties to the agreement, were so “highly sensitive such that its disclosure would cause competitive harm.”  Moreover, the court found that the relationship between the parties to the agreements at issue and the terms of those agreements were important facts necessary for a resolution of the case, and thus could not be withheld justifiably from the public.

Takeaway: A high threshold must be met, even by non-parties, in order to keep from the public the documents that become part of a lawsuit, either prior to trial or during trial.

Chancery Reviews Fiduciary Duties of Independent Board of Directors

A recent Delaware Court of Chancery decision addressed how the court will review claims against an independent and disinterested board for breach of the duty of loyalty in connection with a merger transaction. The opinion styled Kahn v. Stern, C.A. No. 12498-VCG (Del. Ch. Aug. 28, 2017), involved allegations made unsuccessfully, that the board of directors breached their duties as a result of side deals that allegedly were made in connection with a merger that personally benefited the directors in an inappropriate manner.  Allegations were also made unsuccessfully that insufficient information was provided to stockholders before a majority approved the merger by written consent.

The detailed facts are essential for a complete understanding of the decision by the court, however, for purposes of this short blog post a focus on the court’s analysis and its application of the legal principles involved has the most widespread usefulness.

A critical determination was the court’s finding that three of the five board members were considered independent and disinterested. That determination by the court impacted the standard of review that the court applied.

The court began its legal analysis with a review of the requirements that a complaint must satisfy in order to prevail on a motion to dismiss, which was the procedural posture in which the decision in this case was made. In particular, where, as here, there was no controlling or majority stockholder, and the court found that three out of the five directors were considered independent, the complaint was required to include “sufficient facts to show that a majority of the board of directors breached the fiduciary duty of loyalty.”

That is, because the court found that a majority of the board was not dominated or controlled by an interested party, the board enjoyed the presumptions of the business judgment rule.  Generally, under the business judgment rule, the court will not second-guess well-informed, independent and disinterested board decisions.  Notably, there was no enhanced scrutiny applicable because no Revlon claim was made that the board did not attempt to obtain the highest possible price for the company.

There was no issue whether two of the five directors were considered independent and disinterested. The determining factor was whether the third director, Joseph Daly, could be so described.

In the court’s analysis to determine whether Daly was “disinterested,” which would have resulted in a majority of the board not being disinterested, the court observed that the sole allegation regarding Daly was that he had a large, illiquid block of shares, and that he aligned himself with another stockholder that was supporting the sale of the company, and that Daly was excluded from the special committee.  Daly owned approximately 19.1% of the company, making him the largest single stockholder.  There is no allegation that Daly received different or unique consideration.  Nor does the complaint allege that he faced a liquidity crisis or an urgent need to sell his stock.  The complaint failed to plead a disabling interest of Daly because his incentives were the same as that of other stockholders:  to maximize the value of his interests.

The next issue was whether Daly was an independent director. The court explained that to plead a lack of independence, a plaintiff must plead facts that, if true, overcome the presumption of a director’s faithfulness to his fiduciary duties.  There was no detail in the complaint to support the conclusion that Daly was unable to “objectively make a business decision” concerning the merger.

The court reasoned that in the face of a majority of disinterested and independent board members, and an exculpatory charter provision, in order to survive a motion to dismiss and pursue a post-closing damages claim for breach of fiduciary duty, the plaintiff was required to plead facts making it “reasonably conceivable that a majority of a board acted in bad faith.”

Bad faith will be found if a “fiduciary intentionally fails to act in the face of a known duty to act, demonstrating a conscious disregard for his duties.”  Bad faith may also be found when “the decision under attack is so far beyond the bounds of reasonable judgment that it seems essentially inexplicable on any ground other than bad faith.”

The allegations that the board members approved the merger without knowledge of the side deals and that there were omissions and misstatements in the information provided to stockholders, was insufficient to establish bad faith.  The court reasoned that the complaint did not plead facts that created a reasonable inference of bad faith because the amount of the reduction in the merger price allegedly based on the side deals was never described in detail; more importantly, details to negate the good faith of the independent directors who approved the merger in light of the side deals was absent from the complaint.

The court found that there were insufficient facts in the complaint to support the allegations that the actions of the board members were made without the best interest of the corporation in mind, and there were also insufficient facts to support the argument that it was “reasonably conceivable that the board took action inexplicable on grounds other than bad faith.”

Regarding the disclosure omissions and misstatements, the court observed that if the issues were presented in a pre-closing request for injunctive relief, the court would have employed enhanced scrutiny to review the disclosure allegations, not to determine damages. In a pre-closing procedural context, unlike in the current procedural posture, if appropriate, the court would afford equitable relief in aid of a stockholder pursuing statutory voting or appraisal rights.

By contrast, in this post-closing request for damages, the focus is on whether the directors of the acquired entity are conceivably liable for damages based on a non-exculpated breach of fiduciary duty due to the alleged failure to make material disclosures. Specifically, that would require the plaintiff to point to facts in the complaint to support an inference that the board acted in bad faith in issuing the disclosures, implicating the duty of loyalty – – as opposed to a mere erroneous judgment in the failure to make a disclosure which would implicate the duty of care which in this instance is exculpated by a provision in the charter.

The court explained that in a post-closing claim for damages, information deficiencies that might be found material in support of a claim for injunctive relief pre-closing, may be insufficient to support a claim for damages where, as here, nothing in the record created an inference that the directors deliberately withhold information or disregarded a manifest duty.

Court of Chancery Jurist Co-Authors Article on Drafting

Vice Chancellor J. Travis Laster of the Delaware Court of Chancery co-authored with Ken Adams, an article about agreements that attempt to preempt judicial discretion.  Copious footnotes to court decisions and treatises support the helpful analysis and drafting tips provided. The article should be required reading for anyone litigating the meaning of an agreement in the Delaware Court of Chancery–or drafting any document that might be the subject of corporate or commercial litigation in the Delaware Court of Chancery.

Court Enforces Post-Mediation Settlement Terms

A recent letter ruling is useful for commercial litigators for two contract interpretation principles that the Court of Chancery addresses in a business-like manner. In Frank Robino III v. Paul Robino; Charles Robino, et al. (Del. Ch. Aug. 16, 2017), the Court addressed:

(1)        What standard is applied when a person claims that an agreement is not binding due to duress and/or allegations of diminished capacity as a result of substance abuse, including intoxication;

(2)        When a settlement agreement reached during mediation that might not have all the complete formality and comprehensiveness of a typical agreement, can still be enforceable.

Overview

The procedural context of this case was a motion to enforce a settlement agreement that was reached after mediation. Both parties were represented by competent counsel during the mediation, and the court describes the mediator as one of the most experienced mediators in Delaware.  The court granted the motion to enforce a settlement agreement and rejected the two defenses presented.

Rejected Defenses

The first rejected defense was based on the asserted argument of duress as well as substance abuse that apparently included intoxication or inebriation. The court cited to Delaware case law explaining the burden of proof and the challenges in prevailing on such a defense, which was not successful in this case.

Key Holding

Regarding the mediation that resulted in a settlement agreement, the court found that the essential terms of the agreement were agreed to, in a signed document at the mediation. It was not clear whether a more formal and comprehensive agreement was contemplated, although the parties did attempt unsuccessfully to negotiate a more formal and comprehensive agreement after the mediation.  Nonetheless, the court found that the terms that were agreed to and signed at the mediation were sufficient to enforce it as a binding contract.

Court Rejects Post-Closing Adjustment Claims

The Delaware Court of Chancery recently addressed a common type of claim in commercial litigation: Post-closing adjustments to the purchase price. Sparton Corporation v. O’Neil, C.A. No. 12403-VCMR (Del. Ch. Aug. 9, 2017).

Basic Facts: The claims in this case involved an assertion that the defendant directors changed the selling company’s accounts receivable after an amount was determined for an escrow account for post-closing adjustments–but the change was made prior to the closing, unbeknownst to the buyers. In essence, the court found that the allegations of fraud did not satisfy the prerequisites for specificity, and, in addition, a robust anti-reliance clause prevented claims based on representations outside the contract.

Key Takeaways

Anti-Reliance Provision and Fraud Claims

The most noteworthy statement of law from this decision, that has the most widespread application, is based on the strong anti-reliance provision in the agreement, and settled Delaware law that prevented claims based on misrepresentations outside the four corners of the agreement. The anti-reliance clause was quoted at length in the opinion and was very specific to the extent that the parties agreed that the sole and exclusive representations were those contained in the  agreement and that no representations outside the agreement were relied upon in connection with the purchase. (See footnote 44 which cited to the well-known Abry case on which the court’s reasoning was based.)

In addition, the court relied on the basic pleading prerequisites for fraud which require much more specificity than non-fraud claims require. In addition, the court distinguished the Osram case which noted that “a mere allegation that a defendant knew or should have known about a false statement is not sufficient to plead the requisite state of mind” for fraud.The court reasoned that in this case, none of the defendants personally represented the accuracy of the financial statements, and that they were not a position to know the veracity of the statements. Also, the plaintiff did not plead any particularized facts about the roles of the defendant in the company or the relationships of the defendants with management. Nor did the plaintiffs allege any facts to show that the defendants would be a position to know that the documents were falsely prepared.

Commercially Reasonable Efforts

Also noteworthy is the court’s treatment of a claim that “commercially reasonable efforts,” as required by the agreement, were not employed. The case law on the “commercially reasonable efforts standard” has been written about on these pages in connection with recent decisions, but because case law about that contractual standard is not fully evolved, I mention it here in passing even though the court’s discussion is not comprehensive. See Slip op. at page 15.The allegation was that it should have been self-evident that because certain actions did not take place by a certain deadline in the agreement, that the reason must have been the lack of an exercise of commercially reasonable efforts. The court rejected this conclusory allegation because it was not self-sufficient and did not satisfy the “reasonably conceivable test” under Rule 12(b)(6).

Court Rejects Claims for Post-Closing Milestone Payments

A recent decision of the Delaware Court of Chancery deals with a recurring source of litigation: Claims for post-closing contingent payments based on allegations that the requisite milestone was triggered.  The merger in Fortis Advisors LLC v. Shire US Holdings, Inc., C.A. No. 12147-VCS (Del. Ch. Aug. 9, 2017), involved novel pharmaceutical products that were designed to treat dry-eye conditions.

Key Facts: At the time of the merger, some of the products involved had not received complete, final FDA approval, and therefore post-closing payments were based in part on whether or not the necessary final approvals would be obtained, as defined in the agreement.

In essence, the court determined that the defendant’s reading of the contract was the only reasonable one, and therefore the motion to dismiss was granted.

Key Takeaways

  • The court observed that when the dispositive issue is one involving contract interpretation and the contract has only one reasonable construction as a matter of law, a motion to dismiss is an appropriate procedural approach.
  • Several fundamental contract interpretation principles were applied, including: (1) the canon of construction that to express or include one thing implies the exclusion of the other. In Latin the expression is expresio unius est exclusio alterius. (Note that there is also an important exception to this canon of construction–that was not applicable in in this case.) See footnote 30.
  • The second key principle was that the court will not interpret an agreement in a manner that renders some of the terms superfluous. See footnote 32.
  • The next principle that the court applied was of a procedural nature but of major importance. Namely, an argument raised for the first time in oral argument and not included in the brief will not be considered. The court cited settled law at footnote 32 that a party waives an argument by not including it in its brief.
  • The court relied on the rule that when schedules are attached to and incorporated into an agreement, they form part of the entire agreement equal to the terms in the body of the agreement. See footnote 40. The court also relied on the settled rule of contract interpretation which requires that the court prefer specific provisions over more general ones. See footnote 60.

Claims Allowed to Proceed Based on Entire Fairness Standard

The recent Chancery decision in Buttonwood Tree Value Partners, L.P. v. R.L. Polk & Co., Inc., C.A. No. 9250-VCG (Del. Ch. July 24, 2017), is noteworthy for its application of the entire fairness standard to a controlling stockholder transaction, and the observation that exculpatory provisions barring director liability for violations of the duty of care do not apply to a defendant in his capacity as a controlling stockholder. See footnotes 91 and 92.

Key Facts: The Polk family collectively owned more than 90% of the common stock of the company; the directors connected with the Polk family exercised a control block; they engineered a self-tender that allowed them to maintain their control; they set the price through the use of a financial advisor that also did work for the Polk family; within around two years of the self-tender the remaining stockholders received extraordinary dividends amounting to 1/3rd of the self-tender price, together with merger consideration of 300% of the self-tender price. Based on those facts, the court explained that the controlling defendants had the burden to demonstrate that the transaction was entirely fair at the time it was made. They were not able to satisfy that burden.

Key Takeaways 

  • When a transaction involves self-dealing by a controlling stockholder the applicable standard of judicial review is entire fairness. That standard imposes on the defendants the burden to prove that the challenged transaction with the controlling stockholder was entirely fair to the minority stockholders.
  • In this context, an exculpatory provision does not apply to the defense of such a challenged transaction by a controlling stockholder because it alleges breach of a duty of loyalty. But the exculpatory provision under Section 102(b)(7) applies to alleged violations of the duty of care.
  • Notably, common familial relationships among holders of a majority of corporate voting power are not per se sufficient to establish a controlling group of stockholders.
  • Likewise, directors and stockholders who are also family members are not necessarily presumed to vote together “as one undifferentiated mass with a single hypothetical brain.” See footnote 93.
  • Even in the context of an entire fairness review, and in the presence of an exculpatory provision, each defendant must be the subject of well-pleaded non-exculpated claims – – that is, a breach of the duty of loyalty. Specifically, the liability of directors must be determined on an individual basis because the nature of their breach of duty, if any, and whether they are exculpated from liability, can vary for each director. See footnotes 100 and 101.
  • Bad faith allegations in this matter did not survive a motion to dismiss. In order to sufficiently plead bad faith, it must be demonstrated that “disinterested directors were intentionally disregarding their duties or that the decision was so far beyond the bounds of reasonable judgment that it seems essentially inexplicable on any ground other than bad faith.” See footnote 102.
  • Another noteworthy discussion in this opinion was the dismissal of a claim against a law firm for the company alleging the aiding and abetting of a breach of fiduciary duty of the board. The court explained that such a claim requires a knowing participating in the breach and damages proximately caused by that breach. The standard for such a claim is intentionally stringent and it turns on the proof of scienter of the alleged abettor.
  • In addition, a claim for aiding and abetting must include factual allegations of knowing participation in a breach which requires that the third party act with the knowledge that the conduct advocated or assisted constituted a breach. Moreover, the element of knowing participation “ requires that the secondary actor have provided substantial assistance to the primary violator.” See footnotes 108 through 112.
  • The court found that the law firm was not alleged to have knowingly participated in the alleged breaches by the board of their fiduciary duties. The court observed the obvious: “Almost all corporate boards retain law firms to advise them on significant transactions         . . . [I]f pleading a plausible breach of the duty on the part of the director or controller is also sufficient to implicate her lawyer as an aider and abettor, a significant and perverse chilling effect on the ability of fiduciaries to obtain legal counsel would result.”
  • Also noteworthy in connection with the dismissal of similar claims against the financial adviser were the following two points: (1) There is no general duty on third parties to ensure that all material facts are disclosed by fiduciaries; (2) “Passive failure on the part of third parties to ensure adequate disclosures to stockholders, without more, cannot support an inference of scienter for knowing participation in a breach.”
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