Chancery Allows Claim for Breach of Fiduciary Duty for Approval of Stock Options in Violation of Stock Option Plan
Pfeiffer v. Leedle, C.A. No. 7831-VCP (Del. Ch. Nov. 8, 2013).
Issue Addressed: Whether the approval of stock option grants that exceeded the maximum number of stock options allowed under the stock incentive plan was the basis for a breach of fiduciary duty claim against both the board that approved it and the executive who received the stock option grants?
Short Answer: Yes.
The Court denied a motion to dismiss under both Court of Chancery Rule 12(b)(6) and Court of Chancery Rule 23.1. The Court found that there was a prima facie showing of a clear violation of the stock option plan and that the board either knowingly or deliberately exceeded its authority by granting options in excess of the number allowed under the plan. That knowing or deliberate violation of the stock option plan implicated a duty of loyalty, the breach of which cannot be exculpated by a charter provision adopted pursuant to Section 102(b)(7) of the Delaware General Corporation Law.
Moreover, the Court found that there was a reasonable inference that the executive who received the options in excess of those authorized by the plan knew or should have known that his receipt of those options was in violation of the plan, which also supported a claim for a breach of his fiduciary duty.
This 26-page opinion provides an excellent overview of the reason for the pre-suit demand requirement as well as the two major tests for determining pre-suit demand futility under Aronson and Rales.
The Court explained the high threshold that needs to be met under the second prong of the Aronson test which in essence requires that one rebut the business judgment rule presumption. That high threshold was met in this case. See footnotes 24 and 25.
The opinion includes a concise reiteration of the business judgment rule as well as a reminder that the business judgment rule does not only protect “correct” decisions. Rather, it also protects “reasonable decisions made by a board that is informed and acting in good faith,” even when those decisions are ultimately incorrect. See footnote 28.
The Court emphasized that the business judgment rule will not be rebutted and demand will not be excused when a plaintiff only alleges that a board merely failed to follow the terms of a stock incentive plan. Such an allegation fails to address the critical question of how the board reached the result that it did. However, when a board knowingly or deliberately failed to adhere to the terms of a stock incentive plan, a plaintiff can sufficiently circumvent the business judgment rule presumption by demonstrating that the action of the board was a clear and unambiguous violation of a stock incentive plan. The Court explained a prior decision which involved those facts. That decision was Sanders v. Wang, 1999 WL 1044880 (Del. Ch. Nov. 8, 1999) [coincidentally that decision was issued on the same day in November as the instant decision, albeit 14 years earlier].
The Sanders decision determined that it was not a valid exercise of business judgment for a board to exceed the number of authorized shares allowed by a plan. The Sanders case does not support pre-suit demand excusal whenever the terms of a stock plan are violated, but rather, Sanders teaches that when a plaintiff presents particularized allegations that indicate that the board clearly violated an unambiguous provision of the stock plan, it is proper to infer that such violation was committed knowingly or intentionally and, therefore, that demand should be excused. See footnote 38.
In the instant case, the Court concluded that there were sufficient allegations that the board clearly violated the unambiguous provisions of the stock plan, and therefore pre-suit demand was excused. Although the Sanders case granted judgment on the pleadings for the wrongful authorization of awards under the stock incentive plan, the pleadings in the instant case were not advanced enough for that type of motion.
The Court explained that because the allegations survived Rule 23.1, by necessity they would survive the less stringent standard under Rule 12(b)(6). The Rule 12(b)(6) standard is one of “reasonable conceivability” which asks whether there is a “possibility of recovery” under any reasonably conceivable set of circumstances.
The Court also allowed an unjust enrichment claim against the executive who received the options in excess of those authorized by the plan.
Huff Fund Investment Partnership v. CKx, Inc., C.A. No. 6844-VCG (Del. Ch. Nov. 1, 2013).
This opinion addresses the statutory appraisal remedy and the method used to determine “fair value” which is not the same as “fair market value”, in part because Delaware law does not include the synergies expected from merger as part of “fair value”. This opinion also addresses the admonition in the Delaware cases that the actual merger price, even if the result of a fair procedure, is not necessarily the presumptive upper limit of fair value.
Last week, the American Conference Institute sponsored a “D & O Summit”, co-chaired by Kevin LaCroix, friend of this blog and author of the widely respected blog called The D&O Diary. The summit brought together legal and insurance experts to address recent developments in various types of shareholder and related litigation against directors and officers, and the impact on the D&O liability/insurance landscape. Frank Reynolds of Thomson Reuters provides a helpful overview of key topics covered at the summit.
Postscript: Regular readers no doubt have noticed the unusually sparse posting on this blog over the last two months. The reason is the press of paying clients who have priority over the need to fill this space. However, I’m hopeful that within a week or so I will be able to resume more frequest updates (and catch up on the last few weeks). I appreciate your patience.
We previously highlighted the Court of Chancery decision that upheld a forum selection provision in corporate bylaws that required certain suits involving the internal affairs of the corporation to be filed in Delaware. Boilermakers Local 154 Retirement Fund v. Chevron Corporation, C.A. No. 7220-CS (Del. Ch. June 25, 2013).
Professor Larry Hamermesh writes about the voluntary dismissal yesterday of the appeal of that decision by the plaintiffs, and likely ramifications of that dismissal regarding this important issue.
Costantini v. Swiss Farms Stores Acquisition LLC, C.A. No. 8613-VCG (Del. Ch. Sept. 5, 2013).
Issue Presented: Whether a non-manager of an LLC was entitled to indemnification based on the terms of the LLC agreement.
Short Answer: Not based on the applicable terms.
In the underlying action, Swiss Farms sought damages against Costantini and Kahn for breach of fiduciary duties. That case was dismissed based on a successful defense of laches. Kahn and Costantini now seek indemnification for their fees and costs incurred in defending that fiduciary duty action. Costantini was a member of the board of managers of Swiss Farms, but Kahn was not a manager. The Court reiterated the public policy behind indemnification, which encourages able people to serve in managerial positions.
Permissive indemnification under Section 145(a) and (b) of Title 8 of the Delaware Code is allowable as long as the individual acted in good faith.
In addition to those permissive indemnifications, Section 145(c) provides for mandatory indemnification to the extent that any present or former director or officer has been successful “on the merits or otherwise in defense of any action,” suit or proceeding referred to in subsections (a) and (b) of Section 145.
The Court of Chancery explained that the same policy reasons supporting indemnification for corporate actors also applies to actors for other entities, including LLCs such as Swiss Farms. However, because LLCs are creatures of contract, those terms are controlling. In this case, the LLC chose to import verbatim both the permissive and mandatory indemnification rights for its managing members, officers, employees or agents as provided to corporate actors in Section 145.
The Court did not address whether the corporate statute was binding in light of it being imported verbatim. Nonetheless the Court found that the indemnification provision did apply to Mr. Costantini.
Swiss Farms’ argument, which the Court described as “surprising,” was that because Costantini only prevailed on the technical defense of laches, he did not prevail “on the merits.” However, the language imported from Section 145 allows for indemnification where one prevails on the merits “or otherwise.” The language “or otherwise” allows indemnification where, as in this case, a managing member prevails in any manner.
The LLC provisions mirrored subsections (a) and (b) of Section 145 regarding permissive indemnification, and another provision in the LLC agreement mirrored subsection (c) of Section 145 regarding mandatory indemnification. The permissive indemnification is conditioned on the good faith actions of the indemnitee but the mandatory indemnification provisions are not conditioned on good faith, and require indemnification where the actor has merely prevailed in defense of an action. The latter situation is the one in which Costantini finds himself.
The Court found that it was not reasonable to construe the LLC provisions that mirrored Section 145, to require a good faith condition for the mandatory indemnification coverage.
The Court also viewed as “unfortunate” that corporations and other entities often find broad advancement and indemnification clauses useful for enticing talented people to associate themselves with the entity, only to spurn them once the time for payment arrives. In this case, the Court also found that Constantini was entitled to reasonable fees incurred in pursuing his indemnification rights.
A separate analysis was performed for a separate defendant, Kahn, who was neither a manager of the LLC, nor was he an officer, employee or agent of Swiss Farms, or even a member. Rather, he was a partner in a partnership that was a member. The Court found that Kahn was not within the class of indemniteees covered by the provision. Although the LLC agreement could have been drafted to provide coverage for a broader class of persons who are neither managers, officers, employees not agents, that was not done.
The Court understood the argument that it may appear unfair for one of the successful defendants to be covered by the indemnification provision but not to provide indemnification for another, but that is the result of the language in the LLC agreement which did not include Kahn among those for whom indemnification was provided.
The Court also distinguished the case of Imbert v. LCM Interest Holding LLC, 2013 Del. Ch. LEXIS 126, 2013 WL 1934563 (Del. Ch. May 7, 2013). That case involved a dispute as to whether allegations against the potential indemnitee had been brought in his capacity as a manager, for whom advancement rights applied, or as a member, for whom advancement was not provided in the LLC agreement. It was undisputed in that case that the potential indemnitee was a manager, so the issue was in what capacity the allegations against him were brought. Therefore, the holding in Imbert was found not to be persuasive.
In sum, Costantini was a manager of Swiss Farms and within the class of indemnitiees entitled to indemnification for prevailing on the applicable claim. Even though Kahn also prevailed, he was not entitled to indemnification because he was not within the class of indemnitees covered by the LLC agreement’s indemnification provision.
Activision Blizzard Inc. v. Hayes et al., No. 497-2013, order issued (Del. Oct. 10, 2013). In a rare ruling from the bench, after oral argument, the Delaware Supreme Court reversed an injunction granted by the Court of Chancery in Hayes v. Activision Blizzard Inc., No. 8885, 2013 WL 5293536 (Del. Ch. Sept. 18, 2013). The formal written Supreme Court option was issued on Nov. 15, 2013.
The issue addressed was whether the structure of the deal qualified as the type of business combination that required a vote by public shareholders. In a unanimous ruling, Delaware’s high court ruled that no vote was required. A formal opinion will follow. This is an example of how quickly the Delaware courts can decide cases. This final appellate ruling came about a mere month after the complaint was filed in the trial court.
Winshall v. Viacom International, Inc., Del. Supr., No. 39, 2013 (Oct. 8, 2013).
Issue Addressed: The Supreme Court affirmed a Chancery ruling that Viacom was not entitled to contractual indemnification, and thus was required to release escrow funds. A prior Supreme Court decision in this case from July 2013, regarding arbitrability, was highlighted on these pages here. Three prior Chancery decisions involving these parties, which provide more background details, were highlighted on these pages here, here and here.
The Delaware Supreme Court emphatically reiterated the Delaware motion to dismiss standard under Court of Chancery Rule 12(b)(6), to be one of “reasonable conceivability”, which is akin to “possibility”–and less stringent than the federal “plausibility” standard under the federal version of Rule 12(b)(6), which has been interpreted by the U.S. Supreme Court to be found at some point in the continuum between “possibility and probability.” See footnote 12.
The Court also clarified the standard applicable to the filing cross-appeals, and rejected the view that even if appellee prevailed, appellee must cross appeal to challenge an adverse subsidiary part of the trial court ruling. See footnote 13.
The Supreme Court also rejected claims for breach of implied covenant of good faith and fair dealing.
The Court explained that the duty to indemnify based on a contract will not also include the duty to defend unless the word “defend” is explicitly stated. See footnotes 28 to 30 and 36. The Court concluded that the language of the agreement did not require defense costs in the absence of a breach of an underlying representation or warranty.
ASB Allegiance Real Estate Fund v. Scion Breckenridge Managing Member LLC, C.A. No. 5483-VCL (Del. Ch. Sept. 16, 2013)
This Chancery decision, on remand from the Delaware Supreme Court, awarded attorneys’ fees based on the bad faith exception to the American Rule. The Supreme Court had remanded because the award of fees was originally based on a fee-shifting provision in the contract, but the high court ruled that such was not a proper basis for a fee award because the prevailing party did not actually incur fees in light of their counsel providing free representation as a means of avoiding a malpractice claim.
This opinion provides a useful explanation of the types of litigation behavior that will support an award of fees. For example, in this case the court found that the scorched-earth tactic of filing three separate suits in three separate states regarding this same dispute, was designed primarily to increase the fees incurred by the other party, and to extract a settlement disproportionate to the merits. (To seasoned lawyers, that strategy is a familiar one observed all too often, but rarely are the promoters of that strategy held to account.)
Postscript: Regular readers may notice that blogging has been light over the last few weeks, and it is expected to continue to be light for the next two weeks or so due to the press of business for paying clients–which for a practicing lawyer should be a good thing. Once my schedule returns to a “less frenetic pace” I hope to resume more regular updates.
As part of our annual and semi-annual review of key Delaware corporate and commercial decisions, Kevin Brady and I penned a short overview of several of the key corporate and commercial Delaware decisions from the first half of 2013 for a column called Delaware Insider that appears in the current issue of the American Bar Association’s Business Law Today publication, available at this link.
Frank Reynolds of Thomson Reuters has a helpful article summarizing the key points in this ruling on the fraud exception to the requirement that one must own stock in a company to pursue an derivative action. An excerpt follows on this issue of first impression accepted by Delaware’s High Court on certification from the U.S. Court of Appeals for the Ninth Circuit. (The press of paying clients is the reason that blogging has been light lately.)
Bank of America Corp.’s 2008 rescue merger with Countrywide Financial Corp. left Countrywide investors without shareholder standing to continue their derivative suit against its officers and they can’t use Delaware’s “fraud exemption” to revive it, the state’s highest court has ruled.Frank Reynolds
In an en banc opinion on a first-impression issue, the Delaware Supreme Court unanimously ruled that the Countrywide shareholders didn’t prove that their case was an exception to the state’s “no stock, no standing” rule because they lacked proof that the merger’s main purpose was to kill their suit.