Chancery Explains that Special Litigation Committee Must Only Include Board Members

Why This Case is Important: The Court of Chancery opinion in Obeid v. Hogan, C.A. No. 11900-VCL (Del. Ch. June 10, 2016), will be cited often as a reference guide for fundamental principles of Delaware corporate law and LLC law, including the following: (1) even in derivative litigation when a stockholder has survived a motion to dismiss under Rule 23.1, for example, in which demand futility is an issue, pursuant to DGCL Section 141, the board still retains authority over the “litigation assets” of the corporation, and if truly independent board members exist, or can be appointed, to create a special litigation committee (SLC), it is still possible for the SLC, under certain circumstances, to seek to have the litigation dismissed; (2) if an LLC Operating Agreement adopts a form of management and governance that mirrors the corporate form, one should expect the court to use the cases and reasoning that apply in the corporate context; (3) even though most readers will be familiar with the cliché that LLCs are creatures of contract, the Court of Chancery underscores the truism that it may still apply equitable principles to LLC disputes; (4) a bedrock principle that always applies to corporate actions is that they will be “twice-tested,” based not only on compliance with the law, such as a statute, but also based on equitable principles.

The facts of this case are recited in a comprehensive manner in the court’s opinion, along with scholarly analysis, but for purposes of this short blog post, I will provide bullet points.

Key Points:

  • This opinion provides a roadmap for how a board should appoint a special litigation committee with full authority to seek dismissal of a derivative action against a corporation. See pages 30 to 32.
  • The LLC agreement in this case imported the language of Section 141(c) of the Delaware General Corporation Law regarding the composition of a special litigation committee of the board. This LLC agreement adopted a form of governance that mirrored the management of a corporation and included a board of directors. Therefore, the court applied a corporate law analysis, see footnote 5, including an exemplary explanation of the seminal Delaware Supreme Court decision in Zapata that articulated the controlling corporate law principles in connection with special litigation committees. See page 16.
  • The Zapata case was applied to explain that even if a majority of the board is disqualified by lack of independence, it can still delegate its power to a disinterested committee with full board power to decide to move to dismiss a derivative suit filed against the corporation. This may require that additional members of the board be appointed, if possible, who are truly independent. See pages 22 and 23.
  • The court explained that the SLC has the burden to demonstrate its independence and good faith and that it conducted a reasonable investigation. Moreover, the court has discretion to make its own judgment regarding the soundness of the decision of the SLC. See pages 24 and 25. This opinion provides an excellent explanation of the concept of the SLC.
  • This may be somewhat controversial in some circles, but the court explained its reasoning for why it still has the power and authority to apply equitable principles to LLC disputes. See page 11 at footnote 2. See also a recent article on this topic by Prof. Mohsen Manesh, entitled “Equity in LLC Law“, which addresses this concept and includes a discussion of another recent Chancery decision, In Re Carlisle, Etc.,  announcing the same principle.
  • The foregoing reminder of the court’s equitable powers is related to a bedrock principle that all corporate acts are “twice tested,” based on compliance with both the law and equity. See footnote 12 and accompanying text.

In closing, we are happy to note that the scholarship of a very good friend of this blog, and nationally recognized corporate law scholar, Professor Stephen Bainbridge, was cited in this court opinion at footnote 16. It is not uncommon for Professor Bainbridge’s scholarship on corporate law issues to be cited by the Delaware courts, but it is still worth noting. [In addition to this case, the good professor was also cited in another Chancery decision recently, in the matter styled: Pell v. Kill, No. 12251-VCL, 2016 WL 2986496, at *16 (Del. Ch. May 19, 2016).]

Supplement: Professor Bainbridge provides erudite commentary on this case, and he kindly quotes this post. He also provides excerpts of client memos on this case from the Richards Layton and Morris Nichols firms.

Supreme Court Upholds Chancery’s Advancement Ruling

The Delaware Supreme Court in Andrikopoulos v. Silicon Valley Innovation Co., LLC, No. 490, 2015 (Order) (Del. June 8, 2016), affirmed the Chancery decision which was highlighted here, and which determined that the decision of a receiver to deny advancement rights was not in error, and that claims for advancement were appropriately treated as other unsecured claims without priority. Delaware’s high court supported the discretion of the receiver to use other funds to pursue litigation against the former officers but not to approve payments for advancement. This is a somewhat unusual context of a receivership under Delaware law as compared to bankruptcy.

Frank Reynolds of Thomson Reuters has penned a helpful article that provides highlights of the recent oral argument, shortly after which the court entered a terse order with its ruling. (The Supreme Court Building in Dover is shown at right, in a photo from the court’s website.)

Chancery Awards Advancement to Non-Party

For those of us who follow the decisions of the Delaware courts on the right to advancement of fees for officers, directors and others who have been sued in their official capacity, a recent decision within the past week or so from the Delaware Court of Chancery should be of interest. In Thompson v. Orix USA Corp., C.A. No. 11746-CB (Del. Ch. June 3, 2016), the court determined that a former CEO was entitled to advancement rights even though he was not named as a party in the underlying lawsuit.

Most arguments opposing advancement fail when they challenge the satisfaction of the requirement that the underlying suit was brought “by reason of the fact” that the claimant was sued in their corporate capacity, but the charter of Orix USA, one of the two entities involved, provided advancement not only for officers and directors, but also for employees who were sued “by reason of the fact” of that status. This is an unusually broad provision that made it easy for the court to avoid the more common issue of whether the claims being made were based on status of the claimant as an officer or director. The court found that the misappropriated information, which was alleged to have been taken in the underlying action, was accessible to all employees and, therefore, it was not necessary to establish that the corporate powers of an officer and director were used to misappropriate that information.

The applicable language in the charter that provided for advancement also made it easy to argue that it was not necessary that the former directors and employees be named parties in the underlying lawsuit because the charter only required that they be “involved in” litigation even if they were not named as a party. The court found that there was a sufficient basis to establish that the claimants were incurring expenses in connection with depositions and document production that satisfied this requirement even if they were not named parties.

The specific language of the corporate charter involved, as well as a separate LLC agreement that provided relevant rights in light of claims related to that affiliated entity, were dispositive to the extent that they provided for broader rights than are typically allowed in most advancement disputes. These dispositive documents on which the rights were based allowed the court to distinguish several prior advancement decisions cited in footnotes 25, 26 and 30. For example, the court distinguished Paolino v. Mace because even though an employment agreement was involved in that decision, the causal nexus test used to interpret the “by reason of the fact” requirement, was still satisfied. The court reasoned that the requirement is satisfied where, as here: “a claim against a director or officer [or in the instant case, an employee], is for matters relating to the corporation . . . even if the individual is a party to an employment agreement.” This is meant to separate advancement claims from disputes only related to an employment agreement.

Also, because the plaintiffs were not parties to the litigation for which they sought advancement, they needed to allocate their expenses that they incurred as opposed to the expenses for the entity that was sued, and for which advancement expenses were not allowed.

The court also made a distinction between the language in the charter of one of the entities involved, which only required that a person “be involved in” a proceeding, with a separate LLC agreement. That separate agreement was also relevant because the plaintiffs were also claiming an entitlement to advancement under that LLC  agreement which had a requirement that the person claiming advancement be either “threatened to be made a party”, or merely be one who was “threatened” with a lawsuit. The court found a sufficient basis to conclude that those requirements were met. The court also awarded fees on fees as is customary for those portions of the advancement claim that succeeded.

More Directors and Officers Subject to Lawsuits in Delaware

We previously highlighted on these pages a Delaware Supreme Court decision in Hazout v. Tsang, that expanded the orthodox interpretation of a Delaware statute with the net result of making it easier to sue in Delaware an officer or director who has agreed to serve in that capacity for a Delaware entity. Now, readers have the benefit of an expanded article I wrote on the case that appears in the current edition of the national publication of the National Association of Corporate Directors, called Directorship.

Postscript: Professor Bainbridge graciously links to this post.

Delaware Supreme Court Addresses Direct v. Derivative Claims

CITIphoto-Suzanne-Plunkett-150x150The difference between a direct claim by a stockholder against a corporation as compared to a derivative claim, is a subtlety that even the most astute corporate litigator cannot always easily discern. Many Delaware court opinions have addressed the nuances that distinguish between such claims–and to make it more interesting for everyone the Delaware Supreme Court has stated that some claims are both derivative and direct. This week, the Delaware Supreme Court addressed the issue again, considering a matter it accepted upon certification by the U.S. Court of Appeals for the Second Circuit.

In Citigroup Inc., et al. v. AHW Investment Partnership, et al., No. 641, 2015, 2016 WL 2994902 (Del. May 24, 2016), Delaware’s high court explained that because the claims did not involve corporate governance or fiduciary duty issues, that Delaware law did not apply to the direct versus derivative conundrum. Frank Reynolds of Thomson Reuters has a more detailed article about this case.

Chancery Addresses Nuances of Advancement Claim

For those of us who follow the latest developments in the law of advancement claims for directors and officers, a recent transcript ruling should be of interest, due to circumstances not often addressed in advancement decisions that we have highlighted on these pages for the last decade. Courtesy of Kyle Wagner Compton of The Chancery Daily fame, we bring you highlights of a recent decision in the pending case of Eric Pulier v. Computer Sciences Corp., et al., C.A. No. 12005-CB, hearing (Del. Ch. May 12, 2016), heavily borrowing from the unparalleled reporting of TCD‘s indispensable coverage of all things Chancery. Based on what I have seen so far, this may warrant inclusion in my annual ABA book chapter in which I note key decisions on advancement and indemnification. A key issue addressed in this case was whether the claimant was an officer as that term is defined in the applicable bylaws.

TCD alerted us to the following highlights, which are in large part from Kyle Wagner Compton of TCD (though any errors are my own).

The issue was not the usual argument about whether the former officer was acting in a corporate capacity, but instead: whether plaintiff is in fact a “covered” or “indemnified” person subject to advancement and indemnification under defendant’s bylaws. The analysis depended in part on Nevada law, because defendant is a Nevada corporation, and in part on the wording of defendant’s bylaws regarding who qualified as a “vice president” or other officer.

The claimant was the founder and CEO of the acquired company, called ServiceMesh, which defendant — Computer Sciences — acquired for a few hundred million. Plaintiff was kept on to manage his former company as a division of the acquiring company, essentially continuing his pre-existing CEO role, and given the title of Vice President.  The plaintiff was not elected by the board of directors, and thus not entitled to advancement and indemnification under Computer Sciences’ bylaws. The acquiring company sued plaintiff for taking actions as a D&O of the acquired company before closing that weren’t discovered until after closing.  There are two potential bases for advancement: the acquired company’s bylaws for acts taken in the capacity of D&O of the acquired company before closing, and defendant’s bylaws for acts taken in the capacity of Vice President after closing.

Given the nature of his role, one might easily assume that one holding the title of Vice President would be considered an officer of the company.  There is other evidence, such as his being identified as a member of Computer Sciences’ “executive team.”  But Nevada law, which governed the application of the acquiring company’s bylaws, specifies that you can only be a corporate officer in a manner specified in the company’s bylaws, and Computer Sciences’ bylaws specify that officers must be elected by the board of directors.

Other claims, however, were governed by the former company’s bylaws which did not have that prerequisite of election by the board to qualify as an officer for purposes of advancement claims. The Chancellor concluded that five out of seven claims asserted against plaintiff related to acts taken as D&O of ServiceMesh, his prior company, and the court held that he was entitled to advancement for 80% of his expenses based on ServiceMesh’s bylaws.  Based on the prerequisites of the bylaws of the acquiring company controlled by Nevada law, however, the court held that the plaintiff was not entitled to advancement for post-closing acts where his only basis for advancement was under the Computer Sciences’ bylaws.

Takeaway:  This case exemplifies the risk of not being aware that notwithstanding: (a) one’s hiring as a consequence of an acquisition of a company that one founded; (b) assuming responsibility for the management of that business as a division of the acquirer; (c) performing the same types of duties performed as CEO before the acquisition; and (d) with a title like Vice President that is at least nominally an officer-like title, it is still possible based on the terms of a bylaw or other controlling document, to not qualify as an “officer” for purposes of advancement. Thus, those officers and directors who remain in the service of an acquiring company, and the lawyers who advise them, need to be aware of this issue.

Also courtesy of The Chancery Daily are links to the bylaws involved in this case. Amended and Restated Bylaws of Computer Sciences Corp., Feb. 7, 2012 and Amended and Restated Bylaws of ServiceMesh, Inc., Nov. 14, 2011.

Supplement: Keith Paul Bishop published an article about this case in The National Law Review, kindly linking to this post, and providing insights into the Latin roots of the word “vice” as a helpful supplement to the issue in this case about who qualified as a “vice president”.

POSTSCRIPT: Coincidentally, a somewhat similar issue was addressed at a hearing recently in a separate case before another member of the Court of Chancery. In Aleynikov v. The Goldman Sachs Group, Inc., C.A. No 10636-VCL (Del. Ch. April 28, 2016), after a hearing, the court took under advisement an advancement issue certified to it by the U.S. District Court for the District of New Jersey. The issue turned on whether the person seeking advancement, who was given the title of  Vice President by Goldman Sachs, was an “officer” as that term was defined for purposes of being entitled to advancement pursuant to the applicable governing documents. The recent Chancery hearing was the latest iteration of long-running litigation involving several courts in several states, as reported in Law360 in an article on April 28, 2016. We will be watching closely for the court to render its published opinion in this case, and we will be certain to provide highlights.

Corporate Law Seminar

I have been asked to provide information about the following seminar on corporate law at Rutgers Law School-Camden:

The Rutgers Center for Corporate Law and Governance is presenting a conference on corporate compliance on Friday, May 20, 2016, from 8:30 AM to 3:30 PM, entitled New Directions in Corporate Compliance. The conference will take place at Rutgers Law School, 217 North Fifth Street, Camden, NJ 08102. Additional information and a link to register are available at:  http://cclg.rutgers.edu/event/new-directions-in-corporate-compliance-conference/

CEOs as Social Justice Warriors

Yesterday’s Wall Street Journal featured a front page article about an apparently increasing number of CEOs of public companies who use their companies’ resources, and wield their companies’ resources as a sword, to advocate in their official corporate capacities to advance their favorite social agendas–or to oppose legislation on social policies that they disfavor. Courtesy of highly-regarded corporate law scholar Professor Stephen Bainbridge, we have citations to, and quotes from, a recent law review article by the Chief Justice of the Delaware Supreme Court, in which he reiterates a bedrock principle of Delaware corporate law that corporate directors and officers of for-profit Delaware companies “… must make stockholder welfare their sole end….” Leo E. Strine, Jr., The Dangers of Denial: The Need for A Clear-Eyed Understanding of the Power and Accountability Structure Established by the Delaware General Corporation Law, 50 Wake Forest Law Review 761, 767 (2015).

If a stockholder thought that a CEO of a public company was more focused on social activism than observing his or her duty to maintain a focus on maximizing shareholder wealth, one element of a claim would be the measure of damages. If a company is profitable “enough”, the CEO may “get a pass”. But the recent downward trajectory of the stock price of profitable companies like Apple, which recently lost about $73 billion in market value, and an unrelated petition of over one million people who are boycotting Target department stores due to their position on recent gender issues, may gain the attention of a different type of activist: plaintiffs’ lawyers who specialize in stockholder class actions.

SUPPLEMENT: Kevin LaCroix on his blog The D&O Diary, has a characteristically thoughtful analysis of this issue. Both he and Professor Bainbridge kindly linked to my blog post. The good professor also linked to additional commentary on this issue.

Supreme Court Rules on Duties of Delaware Directors

The Delaware Supreme Court recently ruled on the duties of directors of Delaware corporations who are appointed by particular stockholders. In OptimisCorp v. Waite, Del. Supr., No. 523, 2015, Order (April 25, 2016), Delaware’s high court issued a nine-page Order with several substantive footnotes that provide practical insights for those who need to know what the rights and obligations are of directors who are appointed, for example, by written agreement as a condition of an investment in a company. These members of the board are sometimes referred to as “blockholder directors”, as in a director appointed by someone who owns a block of stock.

The Order affirmed a 213-page opinion by the Court of Chancery that also explored the dark corners of “witness tampering”. See OptimisCorp v. Waite, C.A. No. 8773-VCP (Del. Ch. Aug. 26, 2015). Despite the affirmance of the result, the Supreme Court disavowed the Court of Chancery’s reasoning on the “super-director” theory, and neither endorsed the trial court’s view, nor expressed any controlling opinion, about the part of the lower court’s decision relating to the substance or agenda of a board meeting being selectively withheld from a particular director–especially when the stockholder who appointed that director might have exercised his majority power prior to the meeting to avert an ambush.

Nonetheless, for anyone who needs to know, or is interested in, Delaware law on blockholder directors, as well as witness tampering, this gem-filled ruling is useful for its latest iterations of the Supreme Court’s perspective on these topics. A few selected quotes from the decision follow:

  • “… we are reluctant to accept the notion that it vindicates the board‘s right to govern the corporation to encourage board factions to develop Pearl Harbor-like plans to address their concerns about the company‘s policy directions or the behavior of management. Rather, it has long been the policy of our law to value the collaboration that comes when the entire board deliberates on corporate action and when all directors are fairly accorded material information.8”
  • Footnote 8 is eminently quotable:

“See, e.g., Lippman v. Kehoe Stenograph Co., 95 A. 895, 899 (1915) (Each member of a corporate body has the right to consultation with the others and has the right to be heard upon all questions considered . . . .(citation omitted)); id. at 897 ([T]here is a deeper reason [for not permitting directors to act by proxy] based on the association of each director with each of the others, of which association none of the associates can divest himself while remaining a member. In other words, a director cannot authorize any one to act for him, because his associates are entitled to his judgment, experience and business ability, just as his associates cannot deprive him of his rights and powers as director.); Hall v. Search Capital Grp., Inc., 1996 WL 696921, at *2 (Del. Ch. Nov. 15, 1996) (Absent a governance agreement to the contrary, each director is entitled to receive the same information furnished to his or her fellow board members. (citation omitted)); see also J. Travis Laster & John Mark Zeberkiewicz, The Rights and Duties of Blockholder Directors, 70 BUS. LAW. 33, 35 (2015) (Delaware corporate law embraces a board-centric model of governance. This model expects that all directors will participate in a collective and deliberative decision-making process.); id. at 41 (Given that the DGCL allocates fundamental decision-making power to the board as a whole, and not to any individual director qua director, all directors must have the opportunity to participate meaningfully in any matter brought before the board and to discharge their oversight responsibilities. In more granular terms, directors must be afforded, at a minimum, (i) proper notice of all board meetings, (ii) the opportunity to attend and to express their views at board meetings, and (iii) access to all information that is necessary or appropriate to discharge their fiduciary duties, including the opportunity to consult with officers, employees, and other agents of the corporation.).”

  • “… we do not embrace the Court of Chancery‘s framework for analyzing whether the defendant directors behaved inequitably by intentionally concealing from Morelli and other directors their intention to amend the stockholders agreement. That framework seems to assume that if all directors are required to be given fair notice of the agenda for a special meeting, a director with board appointment rights might in some cases use them, and thereafter elect new directors. That might, of course, happen. But if those directors breach their fiduciary duties, our law has potent remedies that the other stockholders can seek.7”
  • “When a board faction calls a special meeting, and is dishonest about its intention to use that meeting to alter a stockholder‘s board appointment rights, the Court of Chancery‘s analysis should involve a considered evaluation of whether intentional duplicity toward fellow board members is consistent with the fiduciary duties those directors owe to the company and its stockholders, including stockholders who are entitled to rely upon stockholder agreements executed in conformity with the DGCL.10  Biasing that analysis by describing it as involving the creation of a class of super directors is unhelpful. Although it may be that directors who own large amounts of stock and have considerable voting power are entitled to no more fair notice than independent directors, surely they are entitled to equal treatment and we doubt that one would label independent directors super directors if they complained after being blindsided by a board majority at a special meeting. Our law should develop in future cases when the outcome turns on it.” [i.e., not this case.]

 

Supreme Court Raises Threshold to Sue Non-Delaware Corporations in Delaware

 The Delaware Supreme Court decided today, over a dissenting opinion, that a non-Delaware corporation cannot be sued in Delaware, even if it is registered to do business in Delaware, if the basis for the suit against it in Delaware is unrelated to the fact that it is registered to do business in Delaware as a foreign corporation. Genuine Parts Co. v. Cepec, Del. Supr., No. 528, 2015 (April 18, 2016). This ruling should be compared generally with an unrelated recent opinion of the Delaware Supreme Court, in Hazout v. Tsang, highlighted on these pages, that interpreted a statute to make it easier to impose jurisdiction in Delaware over directors and officers of Delaware corporations.

This recent Supreme Court opinion in Genuine Parts needs to be read by anyone who wants to understand the latest iteration of Delaware law on the two types of personal jurisdiction and, in particular, the difference between general jurisdiction and specific jurisdiction as it applies to foreign corporations who are registered to do business in Delaware. The court distances itself from a decision of almost thirty years ago in Sternberg v. O’Neil, 550 A.2d 1105 (Del. 1988), in connection with applying the registration statutes at Sections 371 and 376 of Title 8, as well as the long-arm statute at Section 3104 of Title 10 of the Delaware Code.

In sum, Delaware’s high court applies the U.S. Supreme Court decision in Daimler AG v. Bauman, 143 S. Ct. 746 (2014), to interpret the Delaware statutes requiring foreign corporations to register to do business in Delaware to mean, for purposes of an analysis of personal jurisdiction consistent with the Due Process Clause of the U.S. Constitution, as follows: “In most situations where the foreign corporation does not have its principal place of business in Delaware, that will mean that Delaware cannot exercise general jurisdiction over the foreign corporation.” This ruling has wide application for those engaged in the practice of commercial litigation in Delaware and other types of civil litigation involving corporations.

 

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