Stock Transfer Restrictions Explained

A recent decision of the Delaware Court of Chancery needs to be consulted by anyone who seeks to fully understand the prerequisites under the Delaware General Corporation Law for effective restrictions on the transfer of stock. Henry v. Phixos Holdings, Inc., C.A. No. 12504-VCMR (Del. Ch. July 10, 2017).

The prerequisites under DGCL Section 202 include actual knowledge of the restrictions and consent by the stockholder to the stock transfer restrictions.  The court explained in this useful decision why the requirements of Section 202 were not met based on the facts of this case, and why those restrictions cannot be retroactive unless additional requirements are satisfied.

A longer discussion of this case will be published as part of my regular column for the National Association of Corporate Directors’ publication called Directorship.

Relief Granted for Fraudulent Conveyance

The Court of Chancery recently addressed claims for fraudulent conveyance, and relief available for such claims, in Duffield Associates, Inc. v. Lockwood Brothers, LLC, C.A. No. 9067-VCMR (Del. Ch. July 11, 2017). Court of Chancery Rule 9(b) requires that averments of fraud or mistake shall be stated with particularity, as compared to other claims which may be averred generally.

The court described the elements of Section 1304 of the Delaware Uniform Fraudulent Transfer Act, and referred to remedies available to creditors defrauded by debtors who transfer assets improperly. In this case, there was no genuine issue of material fact as to insolvency.  This opinion has practical application in its description of the prerequisites for establishing a fraudulent transfer under the statute and for providing a reminder that any court of equity has “broad latitude” in crafting a remedy appropriate to the circumstances of a fraudulent transfer.  Those remedies are cumulative and non-exclusive.

In this case, the court granted the remedies sought of constructive trust, a full accounting of the proceeds of distributions, and a disgorgement of any profits or proceeds from the transfers.


More on ABA Model Rule of Professional Conduct 8.4(g)

Much has been written about the new Model Rule of Professional Conduct that the American Bar Association (ABA) adopted in August 2016. My ethics column in the November/December 2016 edition of The Bencher, the national publication of the American Inns of Court, explained how the new ethics rule, which the various states can decide to adopt–or not–expands in an amorphous manner the concepts of discrimination and harassment. That article quoted from law professors who teach legal ethics and constitutional law, as well as other commentators.

Since that publication, which raised questions about the rule, the scholarship on the topic now includes several law review articles, including Andrew F. Halaby and Brianna L. Long, New Model Rule of Professional Conduct 8.4(g): Legislative History, Enforceability Questions, and a Call for Scholarship, 41 J. Leg. Prof. 201 (2016-2017)(Halaby Article); Note, Discriminatory Lawyers in a Discriminatory Bar, 40 Harvard J. Law & Pub. Pol. 773 (June 2017)(Harvard Note).

It is a violation of the new Model Rule 8.4(g) to engage in discrimination based on “race, sex, religion, national origin, ethnicity, disability, age, sexual orientation, gender identity, marital status, or socioeconomic status in conduct related to the practice of law.” Discrimination includes “verbal” conduct that “manifests bias.” The eleven protected categories are not entirely inclusive. Omitted from the classifications are such personal attributes as weight, height and veteran status, for example.

For the first time since I started writing the ethics column for The Bencher over 20 years ago, someone wrote a letter to the editor about my column. The author of that letter about my column on the new rule was the president of the ABA. The issues raised by the new model rule deserve a robust analysis and scholarly debate. A few recent law review articles contribute to that goal. More scholarship on the topic is needed. This short essay merely identifies some of the aspects of the recently promulgated model rule that require further study before being adopted by the various states.

Let’s start with the basic premise that everyone should abhor illegal discrimination and harassment in all its nefarious forms. One of the issues created by the new model rule, however, is that it expands the concepts of both discrimination and harassment in a way that reasonable people can, and do, sincerely differ about. Should we impose serious penalties on, and describe as a violation of legal ethics, conduct that reasonable and ethical people sincerely disagree about for intelligent reasons?

It deserves mention that the membership of the ABA counts for a relatively small fraction of all lawyers in the U.S. Yet, the leadership of the ABA is making normative judgments, and setting moral standards, for a majority of the lawyers in this country on a matter about which most of the country is deeply divided. As the Halaby Article explains, the process used to adopt Model Rule 8.4(g) did not benefit from the same level of participation and the same lengthy comment period as did many of the prior major changes in the rules that govern the legal profession. Remember that these rules subject those who violate them to possible loss of their license to practice law and their ability to make a living.

In their zeal to create a utopia, which some might view as a dystopia, the authors of the new model rule have not avoided the fallacy that the end always justifies the means, or to use another maxim: they threw the baby out with the bath water. We should “keep the baby” and find a more nuanced approach to eliminating the bath water–in this case, unwanted discrimination, harassment and lack of diversity in the profession.

The British statesman William Pitt the Younger was attributed with the observation that “necessity is the plea for every infringement of human freedom.” We can all agree that invidious discrimination and harassment should be condemned, but not everyone agrees that other fundamental rights should be trampled on in order to achieve the goal of banning such discrimination and harassment.

One of the problems with the rule is vagueness. It lacks a definition for what it prohibits: discrimination, harassment and applying that behavior to socioeconomic status, for example. Definitions in substantive law, and other sources, can certainly be used as a reference, but they are not uniform and may not apply in all contexts. The Halaby Article describes the new model rule as being “riddled with unanswered questions, including but not limited to uncertainties as to the meaning of key terms…as well as due process and First Amendment free expression infirmities.” Others are more supportive.

Although the Harvard Note argues that amendments to the new model rule should be made before states begin adopting it, overall it supports a codification of the moral judgment that discrimination and harassment are cardinal sins that must be banned from the legal profession. What constitutes a sin, however, needs to be defined. An inherent problem of the ABA’s attempt to use new Model Rule 8.4(g) to codify moral judgments, is that the ABA membership constitutes a small percentage of all lawyers in America and reasonable people can differ about whether the leadership of that group is the appropriate elite to adopt rules that impact personal behavior beyond the administration of justice–much like the magisterium of a church would articulate rules that apply to all areas of one’s personal life – – not only rules governing the practice of law.

Equitable Jurisdiction Found Lacking in Debt Action

The Delaware Court of Chancery is a court of equity with limited jurisdiction. Contrary to what some may assume, not all corporate and commercial litigation can be heard in this famous court. (Delaware’s trial court of general jurisdiction is the Superior Court.) A recent opinion has practical application for litigators to the extent that it applies the well-traveled, but not often well understood, nuances of the limited scope of the equitable jurisdiction of the Delaware Court of Chancery. Yu v. GSM Nation, LLC, C.A. No. 12293-VCMR (Del. Ch. July 7, 2017).  This letter decision explains the three ways to secure equitable jurisdiction, but the court reminds practitioners that the mere incantation of key words invoking equitable relief will not suffice.

The background of this case includes a request to pierce the corporate veil, about which the Court of Chancery has exclusive jurisdiction. In addition to serving as an example of how difficult it is to successfully pierce the corporate veil, this decision explains why the Superior Court could provide adequate relief to the plaintiff by providing a money judgment.  There was insufficient detail in the pleadings to explain why a money judgment could not be paid, and therefore the court dismissed the complaint with leave to refile or transfer the case to the Superior Court within 60 days pursuant to 10 Del. C. § 1902. See generally footnotes 7, 9 and 10 regarding equitable jurisdiction, and also 10 Del. C. § 342, re: Chancery’s limited jurisdiction.

Also of practical application is the discussion by the court in this letter ruling of the exclusive jurisdiction that Chancery has over equitable fraud claims, but in this case there was no basis for an equitable fraud claim. The use of the words alone to allege equitable fraud claims is not enough.

In addition, the court explained that in some instances the Superior Court and the Court of Chancery may both entertain claims for unjust enrichment, but if the unjust enrichment claim, as in this case, is merely a contract-related theory of recovery that accompanies a breach of contract allegation, then the claim is only legal, and not equitable. See footnote 25.

Fiduciary Duties in Limited Partnerships

For my latest column in Directorship, the publication of the National Association of Corporate Directors, I discuss a recent Delaware Supreme Court decision that addresses fiduciary duties as modified in the context of a limited partnership agreement. The case of Brinckerhoff v. Enbridge Energy Company was previously highlighted on these pages, but the opinion remains required reading for any lawyer who needs to know the latest Delaware law regarding how fiduciary duties can be modified by agreement in non-corporate entities, and the interfacing of those modified duties with the implied covenant of good faith and fair dealing.

Chancery Dismisses Claim Due to Lack of Fiduciary Relationship

A recent letter opinion provides a practical description of the elements required to satisfactorily plead a breach of fiduciary duty claim, as well as a definition of situations where a fiduciary relationship may be found. In Beach to Bay Real Estate Center, LLC v. Beach to Bay Realtors, Inc., C.A. No. 10007-VCG (Del. Ch. July 10, 2017), the Court of Chancery also observed the non-controversial truism that minority members of LLCs generally do not owe fiduciary duties to the LLC or other members.

The court explained that in Delaware a fiduciary relationship may be found in:

“. . . a situation where one person reposed special trust in and reliance on a judgment of another or where a special duty exists on the part of one person to protect the interest of another.” See footnote 68.

Moreover, the court explained that there “must be an allegation of an agreement supplying such a duty or a special relationship creating such a duty.” The court observed that in its experience, “thieves and their victims rarely consider their relationship an equitable one on account of that status alone.  Rather, there must be some repose of special trust . . . or reliance . . ..”

The court allowed, however, for the possibility that “in certain circumstances a minority member of an LLC, with access to confidential information, could stand in a fiduciary relationship to the entity or other members.” But, non-conclusory allegations in support of a relationship creating such a duty were found lacking in the complaint in this case.

As an aside, this decision also features quotes from William Faulkner and colorful language about procedural irregularities concerning this matter.

Chancery Rule 171 Amended To Reduce Word Count For Certain Motions

This post was prepared by Brian E. O’Neill, Esq. of Eckert Seamans.

The Court of Chancery recently announced an amendment to Court of Chancery Rule 171, to take effect on August 1, 2017, regarding word limits to motions and letters to the Court and the requisite certificate of compliance. The word limitations applicable to motions filed pursuant to Rules 12, 23, 23.1, 56 and 65 and to pre-trial and post-trial briefs are the same as exist in current Rule 171.  The amended Rule 171 will require opening briefs for motions filed pursuant to Rules 12, 23, 23.1, 56 or 65 and opening pre-trial or post-trial briefs not to exceed 14,000 words.  The answering brief filed shall also not exceed 14,000 words.  The reply brief shall not exceed 8,000 words.

The principal difference articulated in amended Rule 171 is that “[a]ll other applications [other than pursuant to Rules 12, 23, 23.1, 56 and 65 and pre-trial and post-trial briefs] shall be made by motion without a supporting brief” and shall be limited to 3,000 words or less. The opposition to such motions shall not exceed 3,000 words and the reply shall not exceed 2,000 words.

The Court of Chancery is curtailing the verbiage permitted for the many types of motions which are not governed by Rules 12, 23, 23.1, 56 or 65, such as: motions in limine; motions to compel; motions for certification of interlocutory appeals; motions for leave to amend pleadings; motions to intervene; and motions for new trial. As practitioners are aware, the categories of motions governed by the more limited word count often involve complex legal issues and are often submitted in full-brief format in current practice.  Starting August 1, 2017, brevity will become mandated for these types of motions.

Amended Rule 171 also limits letters to the Court to 1,000 words, and states that such letters should be used for “logistical and scheduling issues” and not for substantive relief.

Amended Rule 171 also will require the word count to be stated in the signature block of the filed document governed by Rule 171(f). This requirement presumably is intended to eliminate the situation where one attorney signs the brief and another person signs the certificate of compliance.  Under the new Rule 171, the signatory(ies) of the brief will also be certifying the word count compliance statement.


Chancery Opinion Reviews Voting Agreements and Director Compensation

The recent decision from the Delaware Court of Chancery in Williams v. Ji, C.A. No. 12729-VCMR (Del. Ch. June 28, 2017), provides important insights into the Delaware law applicable to challenges to voting agreements among stockholders, as well as to director compensation packages. (By the way, Happy July 4th to all my loyal readers. We should all stop to reflect on the blessings of liberty we enjoy on this Independence Day holiday.)Related image

Background Facts: The allegations were based on a plan in which directors granted themselves options and warrants for the stock of five subsidiaries over which the corporation has voting control. Around the time those options were granted, the board transferred valuable assets and opportunities of the corporation to the subsidiaries.  A stockholder challenged the grants as a breach of fiduciary duty due to the excessive value that was given in the form of compensation.  The complaint also alleged that the voting agreements amounted to illegal vote buying to the extent that a stockholder was required to vote its shares in a manner that the board of directors instructed.

Issues Addressed: The key issues addressed included whether the business judgment rule or the entire fairness standard would apply to the decisions by the board to grant themselves options as a form of compensation, and whether or not the voting agreements were deficient in some manner.  The court also addressed the issue of ripeness and whether or not the issues relating to the voting agreement were hypothetical because the voting agreement only represented a small percentage of the voting shares and did not determine the outcome of any elections to date.

Key Legal Principles Addressed: The court relied on a recent Delaware Supreme Court decision that defined ripeness to include claims that have “matured to a point where judicial action is appropriate.”  Moreover: “a dispute will be deemed ripe if litigation sooner or later appears to be unavoidable and where the material facts are static.” (citing XL Specialty Ins. Co. v. WMI Liquidating Trust, 93 A.3d 1208, 1217 (Del. 2014), highlighted on these pages.) In this instance, the court found sufficient static material facts to determine whether entering into the voting agreement constituted a breach of fiduciary duty, and distinguished the decision in In re: Allergan, Inc. Stockholder Litigation, 2014 WL 5791350 (Del. Ch. Nov. 7, 2014), highlighted on these pages, because in that case the court dealt with an interpretation of a bylaw in a hypothetical situation that had not yet come to fruition.

Regarding the standard applicable to executive compensation decisions, the court explained the well-settled Delaware law that: “Self-interested compensation decisions made without independent protections are subject to the same entire fairness review as any other interested transaction.” (citing Valeant Pharm. Int’l v. Jerney, 921 A.2d 732, 745 (Del. Ch. 2007), highlighted on these pages).  The court explained the well-known aspects of the entire fairness standard that include both fair dealing and fair price.  The court also observed that application of entire fairness review typically precludes dismissal of a complaint on a Rule 12(b)(6) motion to dismiss.  Where a complaint is adequately plead that the board lacks independence, and alleges a claim for excessive compensation, the plaintiff “only need allege some specific facts suggesting unfairness in the transaction in order to shift the burden of proof to defendants to show that the transaction was entirely fair.” (citing In re: Tyson Foods, Inc., 919 A.2d 563, 589 (Del. Ch. 2007), highlighted on these pages.) In this case, the court determined that the complaint satisfied that standard by pleading “some specific facts suggesting unfairness” in the options involved–thereby shifting to defendants the burden of proving that the grant of the options was entirely fair.

Regarding the unfair process analysis, the complaint alleged that noone other than the interested directors ever approved the challenged grants.  The grants were also timed around the transfer of valuable assets or opportunities to subsidiaries and the grants were not disclosed as compensation but rather were disclosed in a proxy statement as “related-party transactions.”  The court reasoned that those allegations gave rise “to at least a reasonably conceivable inference of unfair process.”

Regarding the fair price element, the court referred to an allegation where one of the defendants alone was granted the right to 18% of the economic value of one of the subsidiaries which was estimated to be worth $178 million, thereby making his interest worth over $30 million.  The court cited to the 1995 decision in Steiner v. Meyerson, 1995 WL 441999 at * 7 (Del. Ch. July 19, 1995), which refused to grant a motion to dismiss when merely $20,000 per year compensation for director service was challenged under the entire fairness standard.  [Of course, most readers will be familiar with the Delaware decision involving the Disney Company where the court found that a payment of approximately $140 million for severance pay to an executive named Ovitz, who was only at the company for about one year and whose performance was less than stellar, was not found to be in violation of the board’s fiduciary duty.  Therefore, specific facts and circumstances matter, and the amount of compensation is not necessarily determinative.]

Regarding the voting agreement issue, DGCL Section 218(c) explicitly authorizes certain voting agreements to be entered into.  The Court of Chancery in unrelated decisions in the past, previously ruled that the transfer of stock voting rights without the transfer of ownership is not per se illegal.  See footnote 31.  In order to be illegal, a vote-buying agreement must have as its primary purpose either to defraud or in some way to disenfranchise other stockholders.  In a prior decision involving voting agreements, the court explained that two of more stockholders may “do whatever they want with their votes, including selling them to the highest bidder.”  See footnote 35.  However, the counter balance to that statement is that:  “management may not use corporate assets to buy votes unless it can be demonstrated, as it was in Schreiber, that management’s vote-buying activity does not have a deleterious effect on the corporate franchise.”  See footnotes 35 and 36.

In this case, corporate assets were used to buy the votes and based on the facts of this case, the burden shifted to the defendants to prove that the agreement was intrinsically fair and not designed to disenfranchise other stockholders.  Making reasonable inferences in favor of the plaintiff at this early stage, the complaint adequately alleged a disenfranchisement purpose.

Supreme Court Dismisses Post-Closing Adjustment Claim

A recent Delaware Supreme Court decision dismissed a claim for post-closing adjustments to the purchase price for the sale of a company. Anecdotally, almost every merger or acquisition agreement that includes a purchase price that provides for an adjustment after closing for such things as net working capital or an earnout will generate a dispute.  The case of Chicago Bridge & Iron Company N.V. v. Westinghouse Electric Company LLC, No. 573, 2016 (Supr. Ct., June 27, 2017)(as corrected on June 28, 2017), is no exception and the Court’s 48-page opinion provides helpful insights into how the Delaware courts deal with the complex contractual issues involved in such disputes.

Basic Background Facts: This case involved the purchase by Westinghouse Electric Company of a subsidiary of the Chicago Bridge & Iron Company.  Westinghouse designs nuclear power plants and Chicago Bridge builds them.  They had done business together for many years prior to the closing on the purchase of Chicago Bridge’s subsidiary by Westinghouse.  One of the reasons for the purchase was that two nuclear plants that Chicago Bridge had been building were beset by cost overruns and delays, and Chicago Bridge wanted to limit its future exposure.  The deal terms included some unusual provisions such as a bar to post-closing liability for certain representations by Chicago Bridge.  The intent of the deal was to transfer future liabilities on the construction of the two nuclear power plants to Westinghouse.

The deal terms provided for post-closing adjustments to determine net working capital, as well as  earnout provisions. Any disputes regarding net working capital were to be presented to an independent auditor for a binding and non-appealable decision.

As the court explains, the net working capital adjustment was intended to address changes from the date of the signing of the agreement until the date of closing. However, the claims by Westinghouse that it sought to have the independent auditor decide, involved time periods and claims that exceeded that limited scope. Chicago Bridge sought an injunction to prevent Westinghouse from presenting those issues to the independent auditor.  The Court of Chancery ruled in favor of Westinghouse.  The Supreme Court in this decision reversed the opinion of the Court of Chancery and ruled in favor of Chicago Bridge.

Key Legal Principles: The court provides a useful recitation of various aspects of Delaware law on contract interpretation that is especially applicable to complex agreements.  The court observed that as often happens in disputes over complex agreements, both parties asserted that their views of the disputed language were supported by the unambiguous terms of the agreement, but they reached opposite conclusions.  The court explained that an agreement is not ambiguous even though the parties reached contrary conclusions about its meaning. Rather, unless the court determines that its meaning it not susceptible to different reasonable interpretations, it will not be considered ambiguous.

The court engaged in some public policy and doctrinal pronouncements in addition to reciting multiple contract interpretation principles. For example, the court explained that the “basic business relationship between the parties must be understood to give sensible life to any contract.”  The essence of this contract was that the seller would be relieved of any future liabilities for the construction of the plants after closing.  Nonetheless, despite the limitations of post-closing adjustments focusing on net working capital, Westinghouse presented a claim for approximately $2 billion. (A harbinger of the conclusion in this opinion was the Court’s use of an exclamation point in the introductory background facts after the sentence which described the amount of the claim.)

Citing to American Bar Association publications on model stock purchase agreements, as well as treatises commenting on such agreements, the court observed that “purchase price adjustments in merger agreements account for changes in a target’s business between the signing and the closing of the merger.” See footnotes 64 to 68.  The court continued by noting that the definition of “net working capital” in this case, read in conjunction with the entire agreement, required the use of the seller’s past accounting practices rather than a new assessment of those practices’ compliance with GAAP.

The focus of any post-closing adjustment in this matter was required to be based on the application of the past practices used by the seller in accordance with GAAP—but the Court recognized that “GAAP allows for a variety of treatments and different accountants may come to differing views on what constitutes acceptable GAAP treatment . . ..” The court found that it would be unreasonable to interpret the definition of working capital as allowing for a different accounting approach from that used by the seller in their financial statements.

The court reasoned that this approach was a practical one because it would be difficult to account for the changes in the seller’s business between signing and closing if one accounting approach is used to complete the financial statements prior to the signing and another accounting approach was used to make the adjustments for the period between the signing and the closing.

The court also explained that the independent auditor had a very limited role and was not authorized to address any potential issue that might be raised in connection with the purchase agreement. The court cited to other Delaware cases in which an independent auditor, pursuant to the agreement, was authorized to address limited issues but was not given broad authority as an arbitrator. See, e.g., footnote 83.  For example, the independent auditor in this case was not empowered to address claims regarding breach of representations in the agreement.  This is especially so based on the unusual provisions of the relevant agreement that limited any post-closing liability of the seller.

The court also observed, citing treatises on agreements involving mergers and acquisitions, that the financial statement representations are the most important representations in such an agreement. See footnote 87.  The limitation on post-closing liability in the agreement, according to the plain English meaning of the relevant terms, prevented liability for representations regarding those financial statements.

The court discussed several Delaware and New York decisions addressing similar provisions in agreements, and distinguished some and relied on others to support its decision. Citing to prior Delaware decisions, the Supreme Court held that “where the contract expressly provides that the representations and warranties terminate upon closing . . . the parties have made clear their intent that they can provide no basis for a post-closing suit seeking a remedy for an alleged misrepresentation. That is, when the representations and warranties terminate, so does any right to sue on them.” See footnote 88.

See generally, Morris v. Spectra Energy Partners (DE) GP, LP, C.A. No. 12110-VCG (Del. Ch. June 27, 2017)(lengthy opinion issued the same day that interpreted undefined terms in a complex agreement involving an alternative entity. That opinion also provided important insights into the application of Delaware contract interpretation principles.)

M&A Litigation: Standards of Review

A member of the Delaware Court of Chancery has penned a chapter for an upcoming book on stockholder litigation. An overview of the chapter was recently published on the Harvard Law School Corporate Governance Blog. This scholarly writing by Vice Chancellor J. Travis Laster is entitled: Changing Attitudes: The Stark Results of Thirty Years of Evolution in Delaware M&A Litigation. As the title suggests, the work provides an overview of the past and present standards the Delaware courts apply to various types of mergers and acquisition.

When a member of the Delaware court speaks publicly about, or publishes an articulation of, Delaware law on M&A standards, those who toil in the vineyards of corporate and commercial litigation would be well advised to pay close attention.