Posted on July 28, 2010 by Francis G.X. Pileggi

Chancery Addresses Fiduciary Claims by Bankruptcy Trustee; Claim Survives Against Financial Advisor for Aiding and Abetting Fiduciary Duty Breach

In Shandler v. DLJ Merchant Banking, Inc., C.A. No. 4797-VCS (Del. Ch. July 26, 2010), read opinion here, the Delaware Court of Chancery, in a 47-page opinion, addressed fiduciary duty claims brought against the controlling shareholder of a bankrupt company as well as its board of directors and financial advisor.

Overview.

Shandler was appointed by the Bankruptcy Court as a Creditor Trustee for Insilco. He brought claims on behalf of Insilco against the controlling shareholder and a majority of the directors affiliated with the controlling shareholder, which was a group of DLJ funds. Shandler claimed  that Insilco was victimized by DLJ's breach of fiduciary duties. The Court dismissed most of the counts for either failure to state a claim or because they were exculpated duty of care claims. However some claims that survived in this decision on a motion to dismiss were allowed to proceed because they raised duty of loyalty issues as a result of a transaction between the controlling shareholder and an affiliated entity.

Lastly, KeyBanc, a financial advisor for the challenged deal, was also kept in the case on a claim against it for aiding and abetting the directors' breach of fiduciary duty of loyalty in connection with the challenged deal.

BACKGROUND

Introduction

Although the plaintiff must have known that Delaware does not recognize a claim for "deepening insolvency",  many of the allegations are akin to such a claim, and the Court dismissed those arguments in any event. In essence, a large portion of the allegations complain about a failed strategy by the controlling shareholder, that dominated the board. The strategy included a string of acquisitions in anticipation of an IPO, but instead of positioning the company for an IPO, caused it to become insolvent. Shandler also accused the board of waiting longer than was reasonable to file bankruptcy so that the controlling stockholder could squeeze out more fees and related benefits before submitting to the jurisdiction of the bankrutpcy court. In particular, the Court summarized some of the key factual background as follows:

With the DLJ-affiliated directors making up a majority of the Insilco board, the board allegedly managed Insilco in such a way that benefitted DLJ to the detriment of Insilco. Specifically, Shandler claims that the Insilco board, and DLJ as majority shareholder, engaged in three forms of self-dealing to further the interests of DLJ. First, the board allegedly caused Insilco to retain various DLJ-related companies as financial advisors in connection with several M & A transactions and to facilitate Insilco’s entry into certain credit agreements, and caused Insilco to pay those advisors excessive fees for those roles. Second, the board and DLJ allegedly caused Insilco to sell ThermaSys to a company controlled by the DLJ Funds for an unfair price. Finally, once it was clear that DLJ’s business strategy for Insilco had failed and the company was insolvent, the Insilco board, at the behest of DLJ, supposedly delayed the filing of insolvency petitions for Insilco so as to allow DLJ to recoup some of its losses through the generation of additional advisory fees and through sales by the DLJ Funds of the Insilco debt that they owned. (emphasis added)

Challenged Transaction Suffers from Flawed Special Committee and Faulty Financial Advice

The primary transaction that was challenged involved a sale of the ThermaSys subsidiary,  regarding which Shandler claimed that the controlling shareholder "being on both sides of the deal", sold the division on terms that were unfair to Insilco. The deal also suffered from a lack of the type of procedural protections that would have provided additional defenses. The financial advisor for the deal also labored under a lack of independence. As the Court described it:

 ... Shandler only focuses substantively on attacking one of the transactions, the sale of ThermaSys. In early 2000, defendant [director] Dawson allegedly recommended to Insilco’s CEO Kauer that Insilco engage in a so-called “value creation strategy” which involved Insilco selling ThermaSys for cash, and thereafter restructuring Insilco’s debt (the “ThermaSys Transaction”). Rather than implement that strategy in the usual fashion that would involve the appointment of a special committee of independent directors to, in the first instance, determine whether such a sale was in Insilco’s interest and at what price a sale made sense, the Insilco board instead struck a preliminary bargain whereby an entity in which the DLJ Funds owned a majority stake would buy ThermaSys for $147 million.

Only after the deal terms were struck was defendant [director] Ashton appointed to the board on July 5, 2000 and immediately named as a single person special committee. The resolution appointing Ashton indicated that he was “completely disinterested in the Proposed [ThermaSys] Transaction and [had] no financial interest in common with the proponents of the Proposed [ThermaSys] Transactions.” The complaint alleges that the resolution was misleading, one must assume (as the complaint is otherwise silent on this point) because the resolution does not address the fact that Ashton had served as the CEO of a DLJ portfolio company from 1995 to 1997.

Within five days, Ashton ratified all prior actions of the board related to the deal, including its prior retention of supposedly independent counsel Baker Botts and financial advisor, defendant KeyBanc, a subsidiary of Key Corp., and blessed the $147 million sales price. According to the complaint, Ashton made no effort to negotiate better terms or to seek other buyers for ThermaSys. Rather, Ashton relied upon a fairness opinion by KeyBanc, a banker who Shandler alleges had a previous underwriting relationship with DLJ.

KeyBanc made a presentation on July 14, 2000 at which it conveyed its opinion that the fair value of the ThermaSys Transaction was $143 million as of July 14, 2000 (the “Fairness Presentation”), and, thus, that the $147 million price was fair to Insilco. But, according to the complaint, the Fairness Presentation was flawed because it adopted an EBITDA multiple that was below the floor of the range of EBITDA multiples for automotive transactions during that time period. Specifically, Shandler argues that KeyBanc’s Fairness Presentation represented that the average EBITDA multiple of automotive transactions from January 1998 to July 2000 was 7.7, with the high of that range being 12.3 and the low being 5.6. But, the Thermasys Transaction used an EBITDA multiple of only 4.1. If the Thermasys Transaction had been at the average EBITDA multiple of 7.7, Shandler argues, the price of ThermaSys would have been $274.89 million.

Moreover, Shandler argues that KeyBanc had given DLJMB [one of the DLJ funds that made up the controlling stockholder] a fairness opinion for the ThermaSys Transaction just three weeks before KeyBanc was retained by Insilco. An internal analysis of the Investment Committee of DLJMB valued the ThermaSys Transaction at $174 million as of February 29, 2000, but reduced that valuation estimate to $150 million on June 8, 2000. According to an internal memorandum, DLJMB’s reduced valuation relied, in part, on a fairness opinion that KeyBanc had created for DLJMB. That is, KeyBanc had been advising DLJMB on the ThermaSys Transaction weeks before it was hired by Insilco to provide the same service. (emphasis mine).

Delaying the Bankruptcy Filing

The Court refers to the complaint in turn as contradictory and confusing, but still reads it to allege that for more than one year the conflicted board knew that it was insolvent though it delayed the filing of a bankruptcy petition for several reasons: (i) to try to sell the company before filing; (ii) to avoid the scrutiny of  a bankruptcy trustee that would expose the insider transactions; and (iii) to obtain more fees for the affiliates of the controlling stockholder.

While delaying the bankruptcy, the complaint alleges that the majority controlled board was trying to favor its own position to the detriment of other shareholders. Specifically, Shandler claims that the majority stockholder was conflicted due to the following "hats that it wore": majority equity holder, senior lender, financial advisor, and syndication agent for the company's loans.

Insilco filed a Chapter 11 bankruptcy petition in December 2002. A Liquidation Plan pursuant to Chapter 11 was confirmed and became effective in October 2004. Part of the Liquidation Plan was the creation of a Creditor Trust and the appointment of a Creditor Trustee, Shandler, who filed the instant case.

Procedural Background

Shandler was authorized to bring claims on behalf of the corporation and filed claims in the Bankruptcy Court in 2004, shortly after he was appointed, that largely mirror the claims that were later brought in the Court of Chancery. The Bankruptcy Court dismissed the fiduciary duty claims on the theory that as "non-core claims" the Bankruptcy Court did not have subject matter jurisdiction. After that dismissal was final in October 2008, Shandler filed his fiduciary duty claims in this court in August 2009.

LEGAL ANALYSIS

Indemnification and Res Judicata arguments described by Court as "silly and frivolous"

In the bankruptcy proceedings, the directors and Shandler entered into an Indemnification Stipulation in which Shandler agreed that the directors would be indemnified up to the amount of insurance coverage available for indemnification. The directors argued that the stipulation was an acknowledgment  that the directors acted in good faith because, they argued, Section 145 of the DGCL only allows indemnification for good faith actions of the directors--in their view.

"Silly and frivolous" and lacking in merit or equity, is how the Court described their argument, before rejecting it. The stipulation was only designed to provide for insurance coverage to pay for legal fees and lacked a key element for res judicata--a final prior adjudication. See footnotes 102 to 104.

Non-Exculpated  Fiduciary Duty Claims Survive Against Directors regarding ThermaSys Deal

The Court explains that the well-pled allegations about the ThermaSys Transaction involved both substantive and procedural unfairness, and suffice to survive a motion to dismiss. The Court noted that despite the protestations to the contrary by the directors, they cannot establish the fairness of the transaction on a motion to dismiss. See footnote 108. The Court added that the complaint supports a rational inference that the ThermaSys Transaction was designed to benefit the controlling stockholder at the unfair expense of Insilco.

Director Defendants.

The Court analyzes the claims against the directors on an individual basis. The Court takes a special interest in one director who it describes as the "oxymoronic one man special committee" who approved the interested ThermaSys Transaction a mere 5 days after joining the board, and who later became the CEO of the spun-off subsidiary, ThermaSys. Also worthy of mention was the failure to disclose in the resolution appointing him to the board, that he had previously served as the CEO of a company that was also controlled or affiliated with the controlling stockholder of Insilco. See footnote 111.

Claim Regarding Excessive Fees Rejected

The Court rejected this claim because it merely alleged that "excessive fees" were paid to affiliated entities, but "the complaint does not plead any factual basis to support this mere conclusion." The Court noted the Chancery decision in Nelson v. Emerson, (summarized on this blog), that rejected a similar claim for excessive compensation, in a bankruptcy context, due also to the lack of an adequate basis to support the allegations. See footnote 119.

Claim for "Delaying Bankruptcy Filing" Dismissed

The Court viewed the complaint as fatally lacking any pled facts "that plausibly support an inference that DLJ could rationally benefit from knowingly diminishing Insilco's enterprise value by purposely delaying bankruptcy when DLJ knew that filing was the value maximizing option." See footnotes 127 to 130.

Moreover the Court reasoned that:

"In this regard, it is critical to note that Shandler cannot base his fiduciary duty claim on the premise that the board did not do what was best for a particular class of Insilco creditors. Even when Insilco was insolvent, the board was entitled to exercise a good faith business judgment to continue to operate the business if it believed that was what would maximize Insilco’s value. Although the rambling complaint makes the cursory allegation that the board did not consider strategic alternatives, it then immediately says that the board retained Bain & Company and consulted with a DLJ affiliated workout specialist for just that purpose. The complaint indicates later that efforts to find buyers took place but did not succeed." See footnote 129.

A memorable money quote on this issue comes from footnote 130 and the Trenwick case:

"Directors may, in the appropriate exercise of their business judgment, take action that might, if it does not pan out, result in the firm being painted in a deeper hue of red."

Entities Affiliated with Controlling Stockholder Considered Alter-Egos for Motion to Dismiss

Useful statements of Delaware law regarding the Alter Ego theory of piercing the corporate veil are found in the text of this opinion accompanying footnotes 133 to 139.  Specifically, for purposes of the motion to dismiss, the Court explained that there was enough overlapping of the affiliated entities to allow them at this early pleading stage to be treated as one-entity for purposes of analyzing the actions of the controlling stockholder which was made up of those related entities.

However, an important limitation emphasized by the Court is that if a director is insulated from liability for due care claims by Section 102(b)(7), then a majority stockholder cannot be held liable for the same allegations. The Court explained further as follows:

"Without conflating their existence for all purposes, there is a pleading stage inference that these entities acted jointly together as if they were a single controlling stockholder and on that basis owed fiduciary duties to Insilco.

Because, however, the premise of controlling stockholder fiduciary responsibility is to hold the controller liable for actions its causes using its control of the company’s board, liability under this theory is largely coextensive with the liability faced by the corporation’s directors. That is, a controlling stockholder cannot be held liable for a
breach of the duty of care when the directors are exculpated. The purpose of controlling stockholder liability is to make sure that controlling stockholders do not use
their control to reap improper gains through unfair self dealing or other disloyal acts." See footnote 140.

Aiding and Abetting Claim Survives Against Financial Adviser

In light of this blog post already being much longer than is customary, I will cover the last but important part of this opinion in the following bullet points:

  • The allegation is that KeyBanc, as a financial advisor, aided and abetted the board in breaching their fiduciary duty by, for example, knowingly providing a valuation for ThermaSys that was far lower than appropriate
  • Most of the Court's discussion was centered on the defense that the claims were time-barred because they were not part of the original claims in bankruptcy nor were they covered by the Delaware Savings Statute, 10 Del. C. Section 8118(a).
  • Without addressing the esoterica of Section 8118, for those who need to know about the Savings Statute, refer to this opinion and be aware that the Court analogized the Savings Statute to Court of Chancery Rule 15(c)(2) which allows a party to amend a pleading when the amendment arose out of the same conduct, transaction or occurrence that was referred to in the original pleading.See footnotes 159 to 164.
  • KeyBanc argued that Ohio law should apply because its contract with Insilco specified as much, but the Court rejected that argument on the basis that Delaware has a greater interest. The Court distinguished that contract based claim with Delaware's "paramount interest" in addressing claims related to breach of fiduciary duty, even though, or maybe especially since, Ohio does not recognize such a claim against KeyBlanc in this context. See footnotes 165 and 166,
  • The Court does not engage in extended discussion of the elements of the aiding and abetting claim. Rather, relying on its foregoing comprehensive analysis of the breach of the fiduciary duty of the directors, the Court merely describes why the defenses offered by KeyBanc are unavailing for purposes of the motion to dismiss.

 

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Posted on July 28, 2010 by Francis G.X. Pileggi

Court of Chancery Construes Stockholders Agreement and Proxy Agreement to Determine Constituency of Board in Section 225 Case

In this 50-page post-trial decision, the Court of Chancery in TR Investors, LLC v. Genger, C.A. No. 3994-VCS (July 23, 2010), read opinion here, held that: (1) defendant Arie Genger (“Genger”), the founder and former majority owner of Trans-Resources, Inc. (“Trans-Resources”) violated a Stockholders’ Agreement by a transfer of shares; (2) the transfer was not later ratified; (3) Genger had failed to procure an irrevocable proxy giving him voting control of the transferred shares; and (iv) the Trans-Resources board no longer consisted of Genger’s designees. The Court’s decision presents in great detail the Court’s findings of facts after trial. Set forth below is a brief factual overview.  The prior Chancery decision in this case was highlighted here.

Kevin Brady of the Connolly Bove firm prepared this synopsis.

Formation of Trans-Resources and Subsequent Stockholders’ Agreement

In 1985, Genger formed Trans-Resources and his majority interest was held through TPR Investment Associates, Inc. (“TPR”). By 2001, however, Trans-Resources was nearly insolvent. Genger’s close friends, Jules and Eddie Trump, through two entities, TR Investors, LLC (“TR”) and Glencova Investment Co. (“Glencova”) (collectively, the “Trump Group”), approached Genger with an offer to purchase nearly all of Trans-Resources’ bonds. Shortly after buying the bonds, the debt was converted into equity under an Exchange Agreement, giving TR Investors and Glencova a collective 47.15% stake in Trans-Resources.

The parties also entered into a Stockholders Agreement which essentially precluded the transfer of shares to anyone other than a limited number of permitted transferees including Genger, one of his entities, or – for estate planning purposes only – Genger’s family members. At this period in time, Genger was involved in a bitter family dispute so the purpose of the Stockholders Agreement was to make certain that the Trump Group would be dealing only with Genger or one of the entities he controlled. An attempt to transfer shares to someone else triggered a right of first refusal for the other party to the Stockholders Agreement. If a transfer was made in violation of the Stockholders Agreement, the transfer could be deemed void. Alternatively, the Trump Group could purchase TPR’s shares in Trans-Resources if Genger had either made an impermissible transfer or effectuated a change of control in TPR.

Genger Transfers Shares in 2004; Trump Group Not Notified Until 2008

In 2004, as part of a drawn-out and contentious marital settlement, Genger agreed to transfer his equity interest in TPR to his ex-wife and to two trusts for his children (the “Orly Trust” and the “Sagi Trust”). Genger did not notify TR Investors or Glencova as required by the Stockholders Agreement. However, Genger alleged that he orally informed Jules Trump, despite the latter’s disagreement as to that representation.

By 2008, Trans-Resources was back in financial trouble so Genger again turned the Trumps for help. The Trumps were able to negotiate a reduction of Trans-Resources’ debt and helped craft a Funding Agreement which would provide for a capital infusion into Trans-Resources. During the negotiations, to the surprise of Eddie Trump, Genger acknowledged that TPR was no longer a stockholder of Trans-Resources. Genger later admitted that he did not provide the requisite notice of the transfer, but claimed he had essentially complied with the Stockholders Agreement by controlling the shares through irrevocable lifetime proxies in favor of Genger.

Subsequently, the Trans-Resources board approved the Funding Agreement which provided that the Trumps would invest an additional $57.5 million in exchange for 50% of Trans-Resources’ outstanding stock which would give the Trumps voting control of the company. Genger initially agreed to the terms of the Funding Agreement, but after he secured an alternative source of funding he backed away from the agreement.

Genger then alleged for the first time that he had orally notified Jules Trump of the transfers in 2004 and threatened litigation if the transfers were challenged. The Trumps then indicated that Glencova was exercising its right under the Stockholders Agreement to purchase all of the shares that were subject to the 2004 transfer. Glencova then filed an action in the Southern District of New York to enforce the Funding Agreement and its rights under the Stockholders Agreement. The Trumps then purchased the shares of Trans-Resources transferred to the Sagi Trust. Because Sagi Genger had separately acquired control of TPR, the Purchase Agreement for the Sagi Trust shares included provisions stating that the transfer was void, that TPR still owed the shares, and that TPR had to sell them to the Trump Group at 2004 prices.

Trump Group Reconstitutes Board; Files Section 225 Action

With its newly acquired majority position in Trans-Resources, the Trump Group executed a written consent removing Genger from the board and adding four pro-Trump personnel. Genger rejected the written consent and so the Trump Group filed an action pursuant to Section 225 to determine the composition of the Trans-Resources board. The Trump Group alleged that the 2004 transfers were in violation of the Stockholders Agreement and that they had a right to purchase all of TPR’s shares pursuant to that agreement. Genger counterclaimed that the transfers were appropriate because he had provided notice to Jules Trump in 2004. Moreover, Genger claimed that the 2008 purchase of the Sagi Trust’s shares ratified the 2004 transfers and, as a result, Genger controlled the board. The parties settled the action with a stipulated final judgment that the Trump Group’s board designees constituted a majority.

However, two weeks later, the Trump Group moved to reopen the action after having learned that Genger had destroyed information relevant to the Section 225 action in violation of a status quo order. In a separate decision, Genger was found to be in contempt. As a sanction, the Court, among other things, raised his evidentiary burden by one level (for example, from preponderance of the evidence to clear and convincing evidence). With the action re-opened, Genger again argued that the transfers were properly effectuated either through oral notice or ratification. In the alternative, Genger alleged that nonetheless, the Trump Group took the Sagi Trust’s shares subject to the proxies issued in his favor.

Court Finds Stockholders Agreement Violated; No Subsequent Ratification

The Court found that Genger did not notify the Trump Group of the 2004 Transfer until the June 13, 2008 meeting with Jules Trump and as a result, Genger failed to comply with the notice requirement of the Stockholders Agreement. In addition, the Court found that Genger did not meet his “clear and convincing” burden to show that the Trump Group ratified the 2004 transfers. The Court noted that on numerous occasions starting on June 13, 2008, the Trump Group stated that the transfers violated the Stockholders Agreement. Moreover, Genger failed to show that there was a benefit to the Trump Group. Instead, it was Genger who ultimately walked away from the Funding Agreement, which would have served as a compromise for Genger’s violations by giving the Trump Group voting control of Trans-Resources. Because the Trump Group was only trying to obtain what it was owed under the Stockholders Agreement -- control of Trans-Resources -- the Court found that its actions did not ratify the transfer.

The Court also held that even if the Trump Group had ratified the transfers, it would still have voting control over Trans-Resources because the Trump Group did not take the Sagi Trust shares subject to the Proxy. The language of the proxy did not suggest that it would run with the shares if they were sold or that there was a reservation of voting powers to Genger after such a sale. The Court noted that because Genger’s interpretation would result in empty voting – a disfavored situation where voting and economic interest are decoupled – public policy required strict construction of the policy. Moreover, where there is an ambiguity, the ambiguity must be construed in favor of not restricting the right to vote.

The Court also found that the proxy failed to satisfy the terms of the governing New York statute which mandates that for a proxy to be irrevocable it must be held by either a pledge, creditor, contract officer or purchaser of the shares, or if there is an agreement between two or more shareholders. None of those requirements were satisfied. As a result, the proxy was not irrevocable under New York law. Since it was irrevocable, it was revoked by the sale of the Sagi Trust shares to the Trump Group.
 

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Posted on July 28, 2010 by Francis G.X. Pileggi

Court of Chancery Addresses Dissolution Issues for Small Start-Up Corporation

In Grimm v. Beach Fries, Inc., et al., C.A. No. 931-VCN (Del. Ch. April 21, 2010), read decision here, the Court issued this post-trial decision in an action for dissolution of a Delaware corporation.

Kevin Brady of the Connolly Bove firm prepared this summary.

In 1999, defendant Little became involved in a mobile concession business that plaintiff Grimm had started a few years earlier. The business involved mobile trailers, fitted out with fryers and other cooking equipment, where French fries and other foods would be sold. Grimm and Little incorporated the business as Beach Fries, Inc., with each owning fifty percent of the stock. As is typical in many start-up companies, one party (Grimm in this case) contributes most of the equity to the venture and the other party (Little in this case) provides the labor.

The business (and their relationship) eventually collapsed and Grimm brought an action for dissolution of the company. Grimm asked the Court to distribute the assets in proportion to the capital contributions of its two owners but the Court denied that request stating the “once the assets were contributed to the Company, they became equally held by the Company and each shareholder owned fifty percent.”

The principal disagreement between the parties that the Court addressed in this decision dealt with which property, if any, currently in each other’s possession is corporate property and, thus, subject to division on dissolution. However, there was little documentary evidence as to the corporate records to support the claims presented by the parties, so the Court was faced with a “he said/she said” trial. After reviewing all of the evidence, the Court determined which property was subject to division and who should get which assets. In the end, the Court dissolved Beach Fries, Inc., awarded Grimm the use of the name Beach Fries, its logo, and the name The Original Beach Fries, as well as one-half of the proceeds of the sale of the certain assets. The Court said that Little may engage in a similar business under a different name and that she was entitled to 50% of the proceeds from the sale of certain of the corporation’s assets and equipment.
 

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Posted on July 22, 2010 by Francis G.X. Pileggi

Chancery Provides "Teachable Moment" for M & A Lawyers: Find Problems of Bidder in Due Diligence or Put Specific Reps in APA; Otherwise No Fraud Claim

Airborne Health, Inc. v. Squid Soap, L.P., C.A. No. 4410-VCL (Del. Ch. July 20, 2010), read opinion here.  Prior Delaware Court of Chancery decisions in this case were highlighted here.

Overview

This case involves a claim against the purchaser of a company and its major law firm for fraud in connection with an Asset Purchase Agreement (APA). The essence of this business litigation claim is that the purchaser, Airborne, fraudulently induced the seller, Squid Soap, to enter into the APA based on misrepresentations about Airborne's ability to grow Squid Soap's business under Airborne's supposedly superior auspices. After the APA closed, major costs incurred by Airborne in connection with the settlement of a class action lawsuit and regulatory investigations, that were pending prior to the APA, severely hampered Airborne and impaired its ability to grow Squid Soap--so much so that Squid Soap claims that after the APA closed, Airborne "killed Squid Soap in its infancy". The Court granted a motion to dismiss the claims.

Legal Analysis

Squid Soap claimed that Airborne was liable to it based on extra-contractual common law fraud. The Court recited the five elements for such a cause of action at pages 12 and 13 of the slip opinion, and also described the three species of fraud, each of which was asserted by Squid Soap: (1) affirmative falsehood; (2) active concealment; and (3) breach of duty to speak. The Court analyzed each in turn. The Court's "teachable moment" to M & A lawyers is offered in part two below.

(1) No Affirmative Falsehood

The Court found that Airborne did not make a material misrepresentation of fact either outside the agreement or in the APA. The representations described at page 10 of the slip opinion regarding the pending litigation against Airborne were sparse and not breached. After reciting the extensive statements made by Airborne to induce Squid Soap to do the deal, the Court described them all as "mere puffery" that because of vagueness are "immunized from regulation". Airborne's bragging about its "very strong brand name" and "established market presence" were not statements that Squid Soap should have relied on. According to the Court: : "A sophisticated seller like Squid Soap, advised by expert counsel, could not reasonably rely on Airborne's boasts and blandishments."

(2) No Active Concealment

The Court observed that Squid Soap's counsel was an AmLaw 100 firm that the Court expected to have "asked questions" based on due diligence checklists and questionnaires that the Court said should have been discussed with Airborne as part of the negotiations for the APA. Footnote 1 of the opinion provided several sources where such checklists are available. The Court found nothing in the record to suggest that Squid Soap's counsel either asked questions before the closing on the APA about the litigation that became problematic, or that Airborne withheld information about the litigation if requested to provide it. Nor did Airborne offer a "half-truth designed to put Squid Soap off the scent ...." Teachable moment: The Court expects M & A lawyers (at least at major firms) to use due diligence checklists or questionnaires to ask about key facts, such as pending litigation, before a deal is consummated, and/or provide for specific representations in the APA about such key facts. Otherwise, a subsequent fraud claim will face an uphill battle.

(3) No Duty to Speak

There was no exception based on a special relationship between the parties, so the Court described the general rule that "one party to a contract is under no duty to disclose facts of which he knows the other is ignorant even if he further knows the other, if he knew of them, would regard them to be material in determining his course of action in the transaction in question." (citing Restatement (Second) of Torts, Section 551 cmt a (1977)). That is, if one's M & A lawyer does not ask about key material facts, and does not obtain representations about those key material facts that later become a source of problems after the deal closes, one should not expect a fraud claim based on non-disclosure of those material facts to have a high probability of success.

Nor did the Court find a disclosure obligation based on a partial disclosure that left a misleading impression even if the partial disclosure was technically true. As a result, in concluding its opinion, the Court dismissed the aiding and abetting claims against the buyer's law firm.

 

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Posted on July 21, 2010 by Francis G.X. Pileggi

Chancery Refuses to Remove Conflicted Arbitrator Chosen by Parties

Milton Investments, LLC v. Lockwood Brothers II, LLC, C.A. No. 4909-VCP (Del Ch. July 20, 2010), read opinion here. This 38-page opinion by the Delaware Court of Chancery addressed two issues that are of practical importance to business litigators.

Procedurally it is noteworthy that within about 6 weeks of the complaint being filed, cross-motions for summary judgment were presented to the Court and it is on that procedural basis that this decision was rendered.

Issues Decided

(1) The arbitrability of a dispute between the only two members of an investment entity; and

(2) Whether an arbitrator chosen by the parties, who had a known conflict of interest when chosen-- due to his prior representation of both parties, should be disqualified based on comments he made prior to a hearing about the issues to be presented to him in the matter to be arbitrated.

Arbitrability Issue

The Court provides a useful overview of the Delaware law of arbitrability and the seminal cases on the topic. In light of no new ground being covered on this issue, however, and the greater importance of the second issue addressed by the Court, this first issue will be treated with brevity. For example, the Court determined  that it was not necessary to distinguish between substantive and procedural arbitrability based on the stipulations of the parties, and that the Court should decide the issue of arbitrability.

Notably, at footnote 44, the Court observed that Delaware mirrors federal law on the issue of substantive arbitrability. See also footnote 48 regarding the issue of who decides arbitrability. Although it did not impact its decision, the Court noted the very recent U.S. Supreme Court decision in Rent-a-Center, West, Inc. v. Jackson, 2010 WL 2471058 (2010). The Court of Chancery distilled the essence of the Jackson case as follows: " ... if a party challenges the enforceability of an agreement to arbitrate, the court would consider the challenge, but if the party challenged the enforceability of the agreement as a whole, the arbitrator should consider it. Id. at *1, 5-8.

In addition most of the Court's discussion was focused on determining whether the arbitration clause at issue should be regarded as either "narrow" or "broad". See  footnotes 48 and 54-55.

Should Arbitrator Be Disqualified Based on Pre-Hearing Statements About Issues for Decision.

The parties had selected in their LLC agreement as the arbitrator for any issues to be arbitrated under the agreement, an attorney that had done legal work for both parties to the agreement. This would have disqualified him due to a conflict as a general matter, but these sophisticated parties knew of the conflict but chose him anyway to be their arbitrator.

The new issue that arose and that was the basis for the argument by one party to disqualify that arbitrator, resulted from comments that the arbitrator made in a letter regarding some of the matters that would be presented to him at the arbitration hearing.

The Court observed that "elementary fairness dictates that arbitrators generally should be neutral and impartial...."  Section 5714(a)(2)  of Title 10 of the Delaware Code gives the Court authority to set aside an arbitration award when "there is evident partiality by an arbitrator appointed as a neutral". See footnote 90.

If the parties sought a neutral arbitrator, Section 5714(a)(2) allows the court to vacate an award, if, for example, the arbitrator  failed to disclose a substantial relationship with one of the parties to the arbitration. As a general matter, if an arbitrator is disqualified, or an arbitrator is unable to serve, another provision of Title 10 of the Delaware Code, Section 5704, authorizes the Court to appoint a new arbitrator.

The analysis in this case must start with the acknowledgement that the parties chose in their agreement an arbitrator that they knew had a known conflict. The Court observed that parties have the ability to agree to a "non-neutral arbitrator" or almost any other procedure to resolve their disputes, other than " ... trial by battle,  or by ordeal, ... or a panel of three monkeys ...."  See footnote 93 and pages 33 to 37.

The Court closely examined the statements by the arbitrator that one party argued was a basis of disqualification, and the Court found those statements to be innocuous. See page 37.  The Court concluded by noting that the parties are free to select an arbitrator with a known, disclosed conflict but that the parties in such a situtation  (in this writer's interpretation), should not expect much sympathy, but in any event, as in this case, such a selection may likely lead to wasteful litigation about the arbitrator's ability to remain impartial.

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Posted on July 20, 2010 by Francis G.X. Pileggi

New York Federal Court Applies Delaware Law to Deny Motion to Dismiss Breach of Fiduciary Duty Claims Regarding Pfizer's Alleged "Off-Labeling" Marketing

On July 14, 2010, the United States District Court for the Southern District of New York, in the case of In Re: Pfizer Inc. Shareholder Derivative Litigation, C.A. No. 09 Civ. 7822 (JSR), read opinion here, issued a decision which denied in part the defendants’ motion to dismiss a derivative complaint alleging, among other things, that present and former directors and senior executives of Pfizer Inc. violated their fiduciary duties under Delaware law, when they “intentionally approved or deliberately disregarded Pfizer’s alleged promotion of off-label drugs and its payment of alleged illegal kickbacks to health care professionals.” The alleged illegal marketing activities took place from 2001 through 2008.

Kevin F. Brady of Connolly Bove Lodge & Hutz LLP provided this summary.

Since 2000, Pfizer had been involved in claims of illegal “off-labeling” marketing resulting in the payment of a number of fines. In September 2009, the United States Department of Justice announced that Pfizer had agreed to a settlement in which it would pay $2.3 billion in fines and penalties arising from illegal “off-label” marketing by Pfizer and one of its subsidiaries of various regulated drugs. Thereafter, several derivative actions were filed seeking to recover from the alleged corporate wrongdoers. The cases were consolidated and on December 16, 2009, the defendants moved to dismiss the Complaint in its entirety. Plaintiffs asserted causes of action claiming that the defendants, among other things: (i) published false and misleading proxy statements and financial statements in violation of federal and state law; and (ii) breached their fiduciary duties to Pfizer by causing or consciously disregarding the illegal marketing activity.

The defendants moved to dismiss the Complaint for failure to plead demand futility. Plaintiffs did not contest that they issued no such demand on the board, but instead argued that demand was excused because the directors’ misconduct could not have been a valid exercise of business judgment, and because a majority of the current board was charged with the alleged misconduct and therefore would be conflicted from assessing the demand.

In a derivative action, the shareholder must either demand that the corporation’s board of directors pursue the action or else show why such demand would be futile. As this Court correctly noted, Delaware law provides alternative tests for determining whether demand would have been futile, one applicable to situations where the board’s business judgment is being challenged (see Aronson v. Lewis) and one where it is not (see Rales v. Blasband). Under Aronson, the plaintiff must allege particularized facts sufficient to create “a reason to doubt that ‘(1) the directors are disinterested and independent [or that] (2) the challenged transaction was otherwise the product of a valid exercise of business judgment.’”

Under Rales, demand is not excused unless the “particularized factual allegations of a derivative stockholder complaint create a reasonable doubt that, as of the time the complaint is filed, the board of directors could have properly exercised its independent and disinterested business judgment in responding to a demand. The Court noted that “[t]his test can be met if the complaint’s particularized allegations raise a “substantial likelihood” of personal liability by a majority of the board.”

The parties here differed as to which standard applied. Defendants argued that the Rales test applied because the Complaint lacked particularized allegations from which it can be inferred that the defendants intentionally authorized the improper marketing practices. Indeed, the defendants claimed that the particularized allegations of the Complaint allege only a failure of oversight, which would implicate In re Caremark International Inc. Derivative Litigation, which meant that “only a sustained or systematic failure of the board to exercise oversight -- such as an utter failure to attempt to assure a reasonable information and reporting system exists -- will establish the lack of good faith that is a necessary condition to liability.” Defendants argued that the Complaint failed to plead demand futility under this standard because there is no question that Pfizer had a reporting system in place and the only particularized allegations of disregard of that system were insufficient to meet the Caremark standard. Plaintiffs argued that defendants “consciously failed to monitor or oversee” the reporting system which “caused and allowed Pfizer to engage in illegal activity.”

The Court agreed with plaintiffs noting that “the allegations of the Complaint evidence misconduct of such pervasiveness and magnitude, undertaken in the face of the board’s own express formal undertakings to directly monitor and prevent such misconduct, that the inference of deliberate disregard by each and every member of the board is entirely reasonable.” As a result, the Court concluded that plaintiffs have pleaded with sufficient particularity that “a majority of directors face a substantial likelihood of personal liability because they deliberately disregarded reports of the illegal marketing practices eventually resulting in the 2009 settlement.” As a result, the motion to dismiss those claims was denied

With respect to the allegations regarding the disclosure issues, the court found that either: (i) the plaintiffs failed to identify any actionable omissions in the proxy materials or financial reports; (ii) defendants did not omit information and that the relevant Proxies contained adequate disclosures; or (iii) defendants did not need to disclose information regarding “self-flagellation” unless it rendered any particular statement false or misleading. As a result, the other counts were dismissed.

 

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Posted on July 19, 2010 by Francis G.X. Pileggi

Company Defenses to Shareholder Proxy Access

Prof. J. W. Verret previews an upcoming article he is writing on the above topic based on Delaware corporate law, which is especially timely in light of the new shareholder proxy access provisions of the new Dodd-Frank Bill that just passed. Here is the link.

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Posted on July 17, 2010 by Francis G.X. Pileggi

Chancery Dismisses Claim that Acquirer Aided and Abetted Breach of Revlon Duty Based on Merger Payments to Preferred Holders and Zero Received by Common Stockholders

In Morgan v. Cash, C. A. No. 5053-VCS (Del. Ch. July 16, 2010), read opinion here, the Delaware Court of Chancery dismissed a claim that the acquirer of a small software company aided and abetted the directors of the acquired company to breach their fiduciary duties in connection with not obtaining the highest value for the company as required by the seminal decision in Revlon, Inc. v. MacAndrews and Forbes Holdings, Inc., 506 A.2d 173, 182 (Del. 1985). Claims against the directors were not addressed in this opinion (only the aiding and abetting claims against the acquiring company.)

Background

The common shareholder who brought this suit (two years after she filed an appraisal action), claimed that the directors of the software company called Voyence breached their fiduciary duties by failing to take reasonable steps to maximize stockholder value in the sale of the company. Specifically, the cash consideration for the merger was only payable to the preferred shareholders who had the right to receive their full liquidation preference in a merger before the common shareholders received a dime. The argument by the claimant in this case was that the board members were mostly designees of the preferred shareholders and they accepted less consideration just so they could receive their liquidation preference at the expense of the common stockholders.

The aiding and abetting claim was based on two points: (i) The acquirer, EMC, attempted to buy off the Voyence management's support for its offer by promising them employment with the post-merger entity; and (ii) EMC exploited conflicts of interest between the Voyence directors, who all held preferred stock or were appointees of preferred stockholders, and Voyence's common stockholders.

Analysis

 The Court announced that: "It is not a status crime under Delaware law to buy an entity for a price that does not result in a payment to the entity's common stockholders. But that is in essence all that the plaintiffs allege that EMC did wrong."

The four elements that must be satisfied to succeed on a claim for aiding and abetting in this context, include: (i) the existence of a fiduciary relationship; (ii) breach of fiduciary duty; (iii) knowing participation in that breach by defendants; and (iv) damages proximately caused by that breach. See footnote 36.

Several cases were cited for the analysis of the "knowing participation" element and how that element can be satisfied by circumstantial evidence--that is, it can be inferred from factual allegations in the complaint in order to survive a motion to dismiss. However, the Delaware Supreme Court has previously explained that a bidder's attempt to reduce the merger price through arm's-length negotiations cannot give rise to liability for aiding and abetting, although a "bidder may be liable to the target's stockholders if the bidder attempts to exploit conflicts of interest in the board or conspires with the board to breach a fiduciary duty." See footnotes 37-38.

The plaintiffs relied primarily on two cases that the Court distinguished in the course of its reasoning to explain why it was dismissing the aiding and abetting claims relating to the argument that EMC exploited conflicts of interest withing the Voyence board to the detriment of Voyence's common stockholders. See Gilbert v. El Paso Co. and Zirn v. VLI Corp. at footnotes 45 and 46.

Unlike the present case where the Court viewed the complaint as silent on the matter, in Gilbert and Zirn, the complaints alleged that the acquirer used its knowlege of the target board's conflicts to collude with and exploit the target board at the expense of the target's shareholders.

The reality, according to the Court, is that there are entities that have a market value that is less than the amount that its preferred shareholders and/or bondholders are due in a sale--which means that the common stockholders would get zero.

The Court stated that Delaware law does not recognize a claim based on the mere fact that a bidder knowingly enters into a merger with a target board dominated by preferred holders at a price that does not yield a return to common stockholders--nor does this situation create an inference that the bidder knowingly assisted in fiduciary misconduct by the target board.

In closing, the Court reasoned that the "... requirement that a third party knowingly participate in the alleged breach--whether by buying off the board in a side deal, or by actively exploiting conflicts in the board to the detriment of the target's stockholders--is there for a reason." See footnote 59 (citing Malpiede, 780 A.2d at 1096)(emphasis in orginal).

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Posted on July 15, 2010 by Francis G.X. Pileggi

Delaware Corporate Law and Hugh Hefner's Playboy Offer

Prof. Stephen Bainbridge discusses here the aspects of Delaware corporate law impacted by the recent offer of Hugh Hefner, as a controlling shareholder of the Playboy company, to freeze-out or otherwise purchase the remaining shares that he does not own already. The good professor also links to the analysis and commentary of other scholars on the topic.

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Posted on July 14, 2010 by Francis G.X. Pileggi

Court of Chancery Approves "Delaware Counsel Only" Restriction in Protective Order

In an unusual but not unprecedented move, the Court of Chancery in Air Products and Chemicals, Inc. v. Airgas, Inc., et al., C.A. No. 5249-CC and In re Airgas Inc. S’holder Litig., C. A. No. 5256-CC, approved a “Delaware Counsel Only” restriction in a protective order.  Read letter decision here. Prior decisions of the Court in this case have been highlighted on this blog here.

Kevin Brady of the Connolly Bove firm prepared this summary.

The Court balanced concerns for the practicality of this limitation on the parties’ New York counsel against  “the risks of inadvertent disclosure of strategic information.” The Court concluded that this restriction “is necessary to assure protection of confidential business strategy information at both Airgas and Air Products.” 

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