Delaware Corporate and Commercial Litigation Blog : Delaware Litigation Lawyer & Attorney : Francis G. X. Pileggi : Corporate, Business, Commercial, Delaware Chancery Court

In Re The Dow Chemical Company Derivative Litigation, Cons. No. 4339, (Del. Ch., Jan. 11, 2010), read opinion here.

Kevin Brady and Ryan Newell of the Connolly Bove firm prepared this synopsis.

On January 11, 2010, a year after a major corporate battle between the Dow Chemical Company (“Dow”) and Rohm & Haas Company (“ROH”) regarding a $19 billion merger, Chancellor Chandler dismissed derivative claims including Caremark-type allegations against Dow’s current directors and officers for failure to adequately plead demand futility under Court of Chancery Rule 23.1.

Anatomy of the Deal -- “Ticking” Fee but No “Financing Out” or MAE Clause

In December 2007, Dow entered into a memorandum of understanding with Kuwait’s Petrochemicals Industries Company (“PIC”) for a joint venture referred to as “K-Dow.” Dow was to receive $9 billion in cash following the transfer of 50% interest in five Dow commodities chemical businesses. In July 2008, Dow entered into an $18.8 billion merger agreement wherein it would acquire all of ROH at $78 per share. The closing was scheduled to occur within 2 business days of receiving regulatory approval. Because Dow recognized that “uncertainty” regarding any aspect of the deal would be a death knell for the deal, Dow did not condition the closing on a financing or any other traditional “outs.” Dow assumed the risk of a material adverse effect in the chemical industry and financial markets. The merger agreement, however, did contain traditional penalties for delay or failure to close including specific performance and substantial “ticking” fees (interest on the cash portion of the deal which was estimated to be approximately $3.3 million per day).

As for financing, Dow had $9 billion from PIC, $4 billion from Berkshire Hathaway Inc. and the Kuwait Investment Authority, and a $13 billion bridge loan (available to be drawn upon if the ROH merger closed before K-Dow closed even though Dow’s position publicly was that the ROH merger was not contingent upon the closing of K-Dow).

Tightening of Credit Markets -- Dow’s Picture Worsens

In July 2008, Dow’s earnings were strong, however, by 2009 Dow’s outlook and the economy in general took a downward turn. Dow’s credit ratings nearly fell to junk bond levels, which possibly meant that either Dow did not have the necessary cash reserves for the ROH deal or, if it closed, Dow would be insolvent following several credit defaults. Dow nonetheless proceeded with pre-closing plans for both K-Dow and ROH.

In late November 2008, Dow received approval for K-Dow from Kuwait’s Supreme Petroleum Council (the “SPC”) to close, which was slated for January 2, 2009. That approval was later rescinded by the SPC (without giving any reason) in late December 2008 – which prompted Dow to quickly issue a press release stating that the ROH closing was not contingent upon K-Dow. (Allegedly, behind the SPC’s rescission were inferences of “external interference,” “politicizing” of the oil industry, and other suspicions that suggested bribery on Dow’s behalf.)

Dow Tries to Extend the Closing

As of January 9, 2009, the only remaining regulatory approval needed was that of the FTC. According to the Plaintiffs, Dow lobbied the FTC to delay approval and also asked ROH to extend the closing deadline. Neither request succeeded. The FTC granted final antitrust clearance for the transaction on January 23, 2009, which triggered a closing no later than January 27, 2009. Two days before closing, Dow refused to close citing two reasons: (i) a change in the economic climate; and (ii) the likelihood that the combined Dow-ROH entity would fail. ROH sued Dow on January 26, 2009 for specific performance. That litigation settled before as trial was about to start and the merger closed on April 1, 2009 “on substantially altered financial terms.”

Derivative Claims

Plaintiffs brought a litany of claims including breaches of fiduciary duties by the Directors for: “(a) approving the [ROH] Transaction, (b) misrepresenting the relationship between the [ROH] and K-Dow transactions, (c) failing to detect and prevent alleged bribery in connection with the K-Dow transaction, (d) failing to detect and prevent the alleged misrepresentations, (e) failing to detect and prevent insider trading, and (f) failing to prevent the payment of allegedly excessive and wasteful compensation.”

Demand Excusal

Plaintiffs, in bringing a derivative action, must satisfy Court of Chancery Rule 23.1 by either making a pre-suit demand or alleging demand futility. The Court stated that the purpose of the demand requirement “is not to insulate [directors] from liability; rather … to preserve the primacy of board decisionmaking regarding legal claims belonging to the corporation.” Demand is futile and therefore excused “only if a majority of the directors have such a personal stake in the matter at issue or the proposed litigation that they would not be able to make a proper business judgment in response to a demand.”

The Court also noted that while the procedural posture was a motion to dismiss, the more liberal standard of Rule 12(b)(6) did not apply. Because the claims were derivative, the motion must be considered under Rule 23.1: “demand futility under Rule 23.1 is ‘logically the first issue [for all derivative claims] and if plaintiffs cannot succeed under the heightened pleading requirements of Rule 23.1 . . . there is no need to proceed to an analysis of the merits of the claim’ under Rule 12(b)(6).” Moreover, two different demand standards applied to Plaintiffs’ claims. For the claims regarding a board action -- the Directors’ approval of the ROH merger -- the Court applied the Aronson test. For claims regarding board inaction (Caremark claims), the Court applied the Rales test.

Approval of the ROH Merger

Under Aronson, Plaintiffs were required to “plead particularized facts that raise a reasonable doubt either (i) that a majority of the directors who approved the transaction in question were disinterested and independent, or (ii) that the transaction was the product of the board’s good faith, informed business judgment.”

First Prong of Aronson

Plaintiffs allege that demand was excused as futile because half of the board failed the test of being disinterested or independent because of their relationships with director Liveris – yet they did not allege that Liveris was interested in the transaction. Plaintiffs pointed to Liveris’ role as a director at Citigroup – which was the named bank among many that were to provide the bridge loan if needed. Under this theory, the Court noted that Liveris potentially had a conflict of interest if ROH had forced Dow to draw upon the bridge loan to close and had Dow consequently gone into bankruptcy. However, this was merely a potential conflict and does not reasonably lead to the conclusion that a conflict existed. With no conflict of interest, there was no interested director and “without an interested director, the Court stated that the independence of the remaining directors need not be examined. Plainly put, the beholdenness or dominance of any director is irrelevant because there is no fear that the dominating director, without a personal or adverse interest, will do anything contrary to the best interest of the company and its stockholders.” With Plaintiffs failing to meet the burden under Rule 23.1, the Court held that the majority of the Directors were disinterested and independent.

Second Prong of Aronson

The Court held that the complaint failed to indicate that the Directors were not adequately informed. To survive the second prong of Aronson, the “‘plaintiffs must plead particularized facts sufficient to raise (1) a reason to doubt that the action was taken honestly and in good faith or (2) a reason to doubt that the board was adequately informed in making the decision.’”

The Court found that “[n]othing in the complaint indicates the Dow board was not adequately informed about the transaction with [ROH].” Taking into consideration the economic times, the Court noted that “[e]ven accepting all the well-pled allegations as true, plaintiffs do not rebut or address the accepted facts that the board was negotiating in a seller’s market and [ROH] demanded certain deal protections.” The Directors made a decision to enter the merger agreement without a financing contingency because they did not want ROH to seek another partner. The Plaintiffs focused on the “substantive content of the directors’ decision” as opposed to the process. As Chancellor Chandler stated in Citigroup, “substantive second-guessing of the merits of a business decision . . . is precisely the kind of inquiry that the business judgment rule prohibits.”

The Court stated:

“To show that a disinterested and independent board acted outside the bounds of business judgment, plaintiffs must show that directors acted in bad faith. Recently, the Supreme Court clarified the concept of bad faith in Lyondell Chemical Co. v. Ryan, noting that ‘[i]n the transactional context, [an] extreme set of facts [is] required to sustain a disloyalty claim premised on the notion that disinterested directors were intentionally disregarding their duties.’ Plaintiffs must show that defendants completely and ‘utterly failed’ to even attempt to meet their duties.”

While the Plaintiffs claimed that the directors misrepresented the connection between ROH and the K-Dow deals, the Court found no misrepresentation of the relationship. Thus, having failed to show reasonable doubt that the Directors did not exercise valid business judgment, the Court held that Plaintiffs failed to satisfy the second prong of Aronson. Coupled with the failure to prove either interestedness or lack of independence, the Court dismissed with prejudice the claim for breach of fiduciary duties regarding the ROH merger.

Caremark Failure to Supervise

Demand futility for the Caremark monitoring claims was governed by Rales wherein:

[D]efendant directors who face a “substantial likelihood of personal liability” are deemed interested in the transaction and thus cannot make an impartial decision. But “[d]emand is not excused solely because the directors would be deciding to sue themselves.” Rather, “demand will be excused based on a possibility of personal director
liability only in the rare case when a plaintiff is able to show director conduct that is ‘so egregious on its face that board approval cannot meet the test of business judgment, and a substantial likelihood of director liability therefore exists.’”

The core of Plaintiffs’ Caremark claims was that the failure to monitor subjected Dow to be exposed to liability for 1) bribery allegations in K-Dow; 2) misrepresentations regarding the need for K-Dow to close to provide financing for ROH; and 3) insider trading and waste allegations.

To prevail on their claim for oversight liability, Plaintiffs

must show that the directors knew they were not discharging their fiduciary obligations or that the directors demonstrated a conscious disregard for their responsibilities such as by failing to act in the face of a known duty to act.” Furthermore, the test is “rooted in concepts of bad faith; indeed, a showing of bad faith is a necessary condition to director oversight liability.” Only an “utter failure” will satisfy a showing of bad faith. Moreover, because Dow has adopted a Section 102(b)(7) provision in its charter, plaintiffs must plead particularized facts showing bad faith in order to establish a substantial likelihood of personal directorial liability.

K-Dow Bribery Allegations

Plaintiffs claimed that the Directors failed to detect and prevent bribery related to K-Dow was “supported” by an unsubstantiated charge made by a Kuwaiti Parliament member. Nonetheless, at the motion to dismiss stage the complaint contained facts that allowed the Court to infer that bribery may have occurred. However, Plaintiffs failed to plead the “red flags” that would give the Directors a basis for suspicion. Plaintiffs argued that because members of Dow’s management may have been involved with bribery issues in the past (Dow paid a fine to the SEC in January 2008), the Board should have suspected similar behavior here. However, the Court rejected that argument because it was found that the prior infractions involved different members of management, a different country, and a different transaction.

Lacking both the knowledge of and reason to suspect bribery, the Directors could not have consciously disregarded their duty to supervise. Nor did Plaintiffs plead facts to suggest an “utter failure” to supervise insiders or that any director acted with anything but good faith. Accordingly, Plaintiffs failed to “allege facts that establish a substantial likelihood of director liability due to oversight liability under Citigroup . . . .” The bribery claim was dismissed with prejudice.

Interestingly, in footnote 85, the Court noted that Dow had set up policies to prevent improper dealings with third parties in its Code of Ethics which expressly prohibited unethical payments to third parties. Plaintiffs also made allegations that defendants permitted their corporate governance policies to be compromised. The Court said in essence that you can’t have it both ways – “Plaintiffs cannot simultaneously argue that the Dow board ‘utterly failed’ to meet its oversight duties yet had “corporate governance procedures” in place without alleging that the board deliberately failed to monitor its ethics policy or its internal procedures.”

Director(s) Domination or Control of Board

Finally, Plaintiffs argued that nonetheless Liveris faced a substantial likelihood for failing to supervise and that he dominated and controlled a majority of the Directors. Without reiterating its reasons, the Court held that Plaintiffs had not pled facts sufficient to show that Liveris, like the other directors, was subject to a substantial liability of interest. Having no conflict, it was irrelevant whether he dominated and controlled a majority of the Directors.

In conclusion, having failed to establish that even one director faced a substantial likelihood of liability, Plaintiffs were unable to show that the board was dominated, controlled, and improperly influenced. Thus, under Rales, Plaintiffs failed to establish that demand was excused so the claims were dismissed.

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In Re Citigroup Inc. Shareholder Derivative Litigation, (Del. Ch., Feb. 24, 2009), read opinion here.

This Delaware Chancery Court opinion should be of widespread interest because it is the first detailed analysis of potential liability of directors under Delaware law for claims relating to a company suffering major losses resulting from substantial exposure to subprime debt.

Kevin Brady, a highly respected Delaware litigator, has graciously collaborated with me to prepare the following detailed review of the case. Readers will recognize Kevin as a regular recent contributor on this blog. This is the first decision, however, where we both collaborated on a summary of the same case. Due to the length of this decision, he focused on the first (and most important) part and I covered the second half of the 58-page opinion beginning with the reference to Chancery's recent AIG ruling (summarized here, which allowed claims to proceed to trial against AIG directors, and is a decision that should be read together with this case.)

This case involves derivative claims brought by shareholders of Citigroup. Chancellor Chandler dismissed all but one of the plaintiffs claims based on a failure to adequately plead demand futility; however plaintiffs’ claim for waste with respect to a November, 2007 letter agreement concerning a payment and benefits package for Citigroup’s CEO survived the motion to dismiss. The Court also denied defendants’ Motion to Stay or Dismiss in favor of a New York action.

This action was brought by plaintiff shareholders against current and former directors:

(i) alleging breach of fiduciary duties for failing to properly monitor and manage the risks that Citigroup faced concerning problems in the subprime lending market; and

(ii) for failing to properly disclose the Company’s exposure with respect to its subprime assets.

Plaintiffs claimed that there were extensive “red flags” starting in May, 2005 that should have put defendants on notice about problems “that were brewing in the real estate and credit markets.” Defendants allegedly ignored the warnings and sacrificed the long term viability of Citigroup for short term profits. The plaintiffs also claimed that the director defendants and certain other defendants were liable for waste for: (i) allowing Citigroup to purchase $2.7 billion in subprime loans in 2007; (ii) authorizing and not suspending the Company’s share repurchase program in 2007 which allegedly resulted in the Company buying its own shares at “artificially inflated prices; (iii) approving a multi-million dollar payment and benefit package in November 2007 for Citigroup’s CEO; and (iv) allowing the Company to invest in “structured investment vehicles” (“SIVs”) that were unable to pay off maturing debt.

Motion to Dismiss or Stay Denied

A related action was filed in the U.S. District Court for the Southern District of New York on November 6, 2007. Four more shareholder lawsuits were filed in New York and all of them were consolidated on August 22, 2008. In the consolidated New York action, plaintiffs alleged: (i) violations of the Securities Act of 1934 §10b-5 and Rule 10b-5; (ii) breaches of fiduciary duties; (iii) waste; and (iv) unjust enrichment. An action was filed in Delaware on November 9, 2007, three days after the first New York action was filed. Ultimately three other actions were filed in Delaware and on April 21, 2008, the four pending Delaware actions were consolidated.

The defendants in the New York  case moved to dismiss the consolidated action. The defendants in the consolidated Delaware action moved to dismiss or to stay the Delaware action in favor of the New York action. After the Court reviewed the legal standard set out in McWane Cast Iron Pipe Corp. v. McDowell-Wellman Eng’g Co., 263 A. 2d 281 (Del. 1970) for staying an action where there is a prior action pending elsewhere and the traditional forum non conveniens analysis, Chancellor Chandler concluded that defendants had failed to meet their burden of showing a hardship that would entitle them to a stay or dismissal of the Delaware action in favor of the New York action. As part of his forum non conveniens analysis, the Court specifically referenced the “important and atypical practical considerations” described by Vice Chancellor Parsons in In Re The Bear Stearns Cos. S’holder Litig., C.A. No-3643-VCP 2008 WL 959992 (Del. Ch. Apr. 9, 2008) as sui generis in that action where, the Court granted a motion to stay in favor of a New York action because “the [Bear Stearns] Court was faced with a case involving the Federal Reserve Bank and the Department of Treasury in which inconsistent rulings could ‘negatively impact not only the parties involved but also the U.S. financial markets and the national economy.” The Chancellor found that those factors were not present here.

Failure to Adequately Plead Demand Futility

Chancellor Chandler started his analysis by referring to the familiar Aronson test for demand futility where plaintiffs must provide particularized factual allegations that raise a reasonable doubt that the directors are disinterested and that the challenged transaction was otherwise the product of a valid exercise of business judgment. However, the Court changed direction when it noted that the plaintiffs here were complaining about board “inaction” and as a result, the Aronson test did not apply. Instead, in order to show demand futility in this situation, the Court turned to the standard set in Rales v. Blasband, 634 A. 2d 927 (Del. 1993) which mandates that a plaintiff must allege particularized facts that “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 the demand.”

In analyzing the plaintiffs’ theory of director liability for failure with respect to the duty to monitor, the Court reviewed the decisions of In re Caremark Int’l Inc. Derivative Litig., 698 A. 2d 959 (Del. Ch. 1996) and Graham v. Allis-Chalmers Manufacturing Company, 188 A. 2d 125 (Del. 1963).

With regard to director liability standards, the Caremark Court distinguished between (1) “a board decision that results in a loss because that decision was ill advised or ‘negligent’” and (2) “an unconsidered failure of the board to act in circumstances in which due attention would arguably, have prevented the loss.” In the first instance, the director’s actions are measured against the business judgment rule. In the second instance, “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 necessary condition for liability.”

Chancellor Chandler then turned to Stone v. Ritter, where he noted that the Delaware Supreme Court approved the Caremark standard of director oversight liability making it clear that liability was based on the concept of good faith which was embedded in the duty of loyalty and did not constitute a freestanding fiduciary duty. Thus, Chancellor Chandler noted that “to establish oversight liability a plaintiff must show that the directors knew that they were not discharging their fiduciary obligations or that the directors demonstrated a conscious disregard for their responsibilities such as failing to act in the face of a known duty to act.” In addition, in order for the plaintiffs to succeed, “a showing of bad faith is a necessary condition to director oversight liability.”

In this case, the Chancellor characterized the plaintiffs’ claims as “a bit of a twist on the traditional Caremark claim” because they alleged that the defendants failed to monitor the Company’s “business risk” specifically with respect to Citigroup’s exposure to the subprime mortgage market. The plaintiffs supported their claim by arguing that the board should have been especially conscious of the “red flags” because a majority of the Citigroup directors served on the board during the Enron crisis and were members of the Audit and Risk Management (“ARM”) Committee and therefore considered “financial experts.” The Chancellor viewed the claims differently. “Although these claims are framed by plaintiffs as Caremark claims, plaintiffs’ theory essentially amounts to a claim that the director defendants should be personally liable to the Company because they failed to fully recognize the risk posed by subprime securities. When one looks past the lofty allegations of duties of oversight and red flags used to dress up these claims, what is left appears to be plaintiff shareholders attempting to hold director defendants personally liable for making (or allowing to be made) business decisions that, in hindsight, turned out poorly for the Company.”

The Court went on to note that the doctrines of the fiduciary duty of care and the business judgment rule have been developed to address those situations. And as a result, the burden was on the plaintiffs not only to show gross negligence but to rebut the presumption that the directors acted in an informed basis, in good faith and in the honest belief that the action was taken in the best interests of the company. In addition, Citigroup had adopted a provision in its certificate of incorporation pursuant to 8 Del. C. § 102(b)(7) that exculpates directors from personal liability for violations of breaches of fiduciary duty, except for, among other things, breaches of the duty of loyalty or actions or omissions not in good faith or that involve intentional misconduct or knowing violation of law. In this action, while the plaintiffs had not alleged that the directors were interested in the transaction, they did allege that the directors acted in bad faith.

The Court concluded that “[a] plaintiff can thus plead bad faith by alleging with particularity that a director knowingly violated a fiduciary duty or failed to act in violation of a known duty to act, demonstrating a conscious disregard for her duties.” Did the director consciously disregard an obligation to be reasonably informed about the business and the risks or consciously disregard the duty to monitor and oversee the business? “The presumption of the business judgment rule, the protection of an exculpatory § 102(b)(7) provision, and the difficulty of proving a Caremark claim together function to place an extremely high burden on a plaintiff to state a claim for personal director liability for failure to see the extent of a company’s business risk.”

In light of the “extremely high burden” placed on plaintiffs, the Court concluded that plaintiffs’ conclusory allegations (and thus their failure to plead particularized facts) were insufficient to state a Caremark claim thereby excusing demand. To the contrary, Citigroup had procedures and controls in place that were designed to monitor risk and the plaintiffs did not contest these standards. Citigroup also had an ARM Committee to assist the board in fulfilling its oversight responsibility regarding risk assessment and risk management. And even if there were warning signs, they are not evidence that the directors consciously disregarded their duties or otherwise acted in bad faith but may only be evidence that the directors made bad business decisions.

The Court also found that the plaintiffs had failed in their attempt to show how the existence of the Enron scandal somehow put the Citigroup directors on “heightened alert” to problems years later with the subprime mortgage crisis. Moreover, the Court found that the use of SIVs in the Enron related conduct would not serve to put the director defendants on any type of heightened notice to the unrelated use of SIVs in structuring transactions involving subprime securities.” “That there were signs in the market that reflected worsening conditions and suggested that conditions may deteriorate even further is not an invitation for the Court to disregard the presumptions of the business judgment rule and conclude that the directors are liable because they did not properly evaluate business risk.”

Recent Chancery Decision in AIG case Distinguished

 The court disagreed with the plaintiffs' characterization of their claims as "failure to monitor" (Caremark) claims, but nonetheless, the court distinguished a recent Chancery Court decision that did allow a Caremark "failure to monitor" claim to survive a motion to dismiss (under a more plaintiff-friendly Rule 12(b)(6) standard.) See American International Group, Inc. Consolidated Derivative Litigation, 2009 WL 366613 (Del. Ch., Feb. 10, 2009) ("AIG case"). Cursory highlights on this blog of the 100-plus page decision in the AIG case by the Delaware Chancery Court that allowed Caremark claims to survive beyond a motion to dismiss can be found here.

The AIG case was distinguishable from this Citigroup case, the court observed, in part because unlike the allegations against Citigroup, the defendant directors in the AIG case: "allegedly failed to exercise reasonable oversight over pervasive fraudulent and criminal conduct. Indeed,  the court in AIG even stated that the complaint there supported the assertion that top AIG officials were leading a "criminal organization" and that the 'diversity, pervasiveness, and materiality of the alleged financial wrongdoing at AIG is extraordinary.'" (emphasis in original).

Contrariwise, the claims against the Citigroup directors involved allegedly failing to recognize the extent of a company's business risk--as opposed to allegedly failing to oversee employee fraudulent or criminal conduct. Caremark-type duties were not designed to impose oversight liability for business risk.

Money quote: "Oversight duties under Delaware law are not designed to subject directors, even expert directors, to personal liability for failure to predict the future and to properly evaluate business risk." (emphasis in original) 

The reasoning for the foregoing statement of Delaware law was explained by means of a query by the court in footnote 78 that deserves quoting verbatim:

... Query: if the Court were to adopt plaintiffs’ theory of the case—that the defendants are personally liable for their failure to see the problems in the subprime mortgage market and Citigroup’s exposure to them—then could not a plaintiff succeed on a theory that a director was personally liable for failure to predict the extent of the subprime mortgage crisis and profit from it, even if the company was not exposed to losses from the subprime mortgage market? If directors are going to be held liable
for losses for failing to accurately predict market events, then why not hold them liable for failing to profit by predicting market events that, in hindsight, the director should have seen because of certain red (or green?) flags? If one expects director prescience in one direction, why not the other?

The court observed that the plaintiffs were asking it to engage in the exact kind of judicial second guessing that the business judgment rule proscribes. Especially in a case with staggering losses, it would be tempting  to examine why the decision was wrong, but the presumption of the BJR against an objective review of business decisions by judges is no less applicable when losses to the company are large.

Disclosure Claims

Plaintiffs argued demand futility regarding their disclosure claims based on the "substantial likelihood of liability" standard which would, they argued, prevent the defendant directors from exercising independent and disinterested business judgment in reviewing a demand. Due to the Section 102(b)(7) provision in Citigroup's charter, such disclosure violations would need to have been done in bad faith, knowingly or intentionally. The court reviewed these claims and found them wanting in the particularity required by Rule 23.1 For example, it was not demonstrated that the directors knew that there were misstatements or omissions in the financial statements, or that they acted in bad faith by not informing themselves adequately. (See footnotes 83 to 87 and 92 to 93 for supporting cases relating to disclosure obligations and detail needed in disclosure violation claims.)

Importantly, the court explained why the allegations against the audit committee were insufficiently detailed for claims involving allegedly faulty financial statements to survive: "Under our law, to establish liability for misstatements when the board is not seeking shareholder action, shareholder plaintiffs must show that the misstatement was made knowingly or in bad faith." In addition, even so-called financial experts on the audit committee are entitled to rely in good faith on reports and statements and opinions, pursuant to DGCL Section 141(e), from the corporation's officers and employees who are responsible for preparing the company's financial statements.

Waste Claims and Demand Futility

 Plaintiffs argued that demand was futile for their waste claims under the second Aronson prong. That is, they do not argue a majority of the directors were not disinterested and independent. Rather, they argue that demand is excused because the "challenged transaction was other than the product of a valid exercise of business judgment". (Clearly, a high threshold.)

In addition to the difficulty of satisfying the second prong of Aronson, the claim of waste under Delaware law is extremely hard to establish. Namely, one must plead particularized facts that lead to the inference that the directors approved an "exchange that is so one sided that no business person of ordinary, sound judgment could conclude that the corporation has received adequate consideration." (footnotes 98 and 99).

The third high hurdle plaintiffs had to jump was that they were attacking a compensation decision.  However, the court noted that  there is "an outer limit" to the discretion of the board in setting compensation, at "which point a decision of the directors on executive compensation is so disproportionately large as to be unconscionable and constitute waste." (footnotes 105 and 106). If waste is found, it is a non-exculpated violation, as the Delaware Supreme Court has held that waste constitutes bad faith. The court's explanation of the compensation package for the departing CEO, who allegedly was at least partially responsible for the staggering losses, and why this waste claim on compensation survived, is worth quoting verbatim:

 According to plaintiffs’ allegations, the November 4, 2007 letter agreement provides that Prince will receive $68 million upon his departure from Citigroup, including bonus, salary, and accumulated stockholdings. Additionally, the letter agreement provides that Prince will receive from Citigroup an office, an administrative assistant, and a car and driver for the lesser of five years or until he commences full time employment with another employer.  Plaintiffs allege that this compensation package constituted waste and met the “so one sided” standard because, in part, the Company paid the multi-million dollar compensation package to a departing CEO whose failures as CEO were allegedly responsible, in part, for billions of  dollars of losses at Citigroup. In exchange for the multi-million dollar benefits and perquisites package provided for in the letter agreement, the letter agreement contemplated that Prince would sign a non-compete agreement, a non-disparagement agreement, a non-solicitation agreement, and a release of claims against the Company. Even considering the text of the letter agreement, I am left with very little information regarding (1) how much additional compensation Prince actually received as a result of the letter agreement and (2) the real value, if any, of  the various promises given by Prince. Without more information and taking, as I am required, plaintiffs’ well pleaded allegations as true, there is a reasonable doubt as to whether the letter agreement meets the admittedly stringent “so one sided” standard or whether the letter agreement awarded compensation that is beyond the “outer limit” described by the Delaware Supreme Court. Accordingly, the Complaint has adequately alleged, pursuant to Rule 23.1, that demand is excused with regard to the waste claim based on the board’s approval of Prince’s compensation under the letter agreement. (footnotes omitted.)

 This post is much longer than normal, but the gravity of this case warrants it. Moreover, I expect that others will be commenting on this opinion, and I will link to that commentary as I encounter it.

UPDATES:  Prof. Larry Ribstein provides insightful commentary here about this case and also the recent AIG case highlighted on this blog. Here is another insightful analysis of this case and the AIG case by Professor Ribstein on the Harvard Law School Corporate Governance Forum.  The AmLaw Daily linked this post here. Professor Lawrence Cunningham comments on the case here.

UPDATE II: Kevin LaCroix's The D & O Diary here has a thoughtful post about this case. Kevin's blog is must-reading for anyone interested in the latest developments on D and O liability and related issues.

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Last year,  I replied to Professor J. Robert Brown's list of the top 5 Delaware cases that, in his view, supported his negative perspective of Delaware law that remains the constant refrain on his blog called: The Race to the Bottom.

My introductory explanation from my rebuttal of last year was as follows:

... I realize that there are many more qualified experts who can rebut the professor's arguments far more persuasively than I, and I am well aware that the Delaware bench certainly does not need my help to defend it. Nor have I been anointed by anyone to take on this role. Nonetheless, having just completed a review of key 2007 Delaware corporate decisions, I offer my own humble rebuttal and a "counter-list" of 5 cases in 2007 that demonstrate that the Delaware courts take shareholder rights and the duties of directors very seriously. If any readers can think of a better "top 5" list, than the one I compiled below, I welcome comments. Here is my top 5 "rebuttal list":

Well, I just finished my 4th annual overview of selected Delaware corporate and commercial cases for  2008, which will be published soon in The Delaware Law Weekly, at which time I will also post it on these pages. I also just saw Professor's Brown list of 5 cases from 2008 that he uses to support his unabashedly unflattering views of Delaware law. Here is his list and here is his introductory post.

My cursory review of the cases I selected below (from the approximately 200 or so that I have summarized on this blog during 2008), is not as scholarly as the good professor's treatment, and I do not have the time (thankfully, due to my busy practice) to engage in extended debate (at least for the next week or so), but until someone else picks up the baton, I offer the following cases to counterbalance the list offered by Professor Brown. I invite others to suggest other cases that they would rather see in my "top 5 list".

•  In Cargill, Inc. v. JWH Special Circumstance, LLC, (Del. Ch., Nov. 7, 2008), read opinion here, the Delaware Chancery Court issued a 68-page decision involving a Delaware statutory trust (formerly referred to as a business trust), and found that common law fiduciary duties would apply to a trustee as a "default rule" in light of the agreement among the parties being silent on the issue. Here is a more complete summary.
• In Julian v. Eastern States Construction Service, Inc.,  2008 WL 2673300 (Del. Ch., July 8, 2008), read opinion here, the Chancery Court required directors to disgorge a $1.3 million bonus they had given themselves in a self-interested manner, without any independent protections, and based on their failure to satisfy their burden to demonstrate the entire fairness of their decision. Here is a more complete summary.
•  In Ryan v. Lyondell Chemical Company, (Del. Ch., July 29, 2008), read opinion here, the Delaware Chancery Court  found that at the procedural stage of a summary judgment motion, it would allow to proceed to trial the issue of whether the independent directors should be exposed to personal liability  for their role in the sale of the company--despite selling the company to the only known buyer for a substantial premium. A whole article could be written on this case alone, and substantial commentary has already been penned about it. An equally weighty later decision denying a motion for reargument was summarized here. The case is now on appeal with the Delaware Supreme Court.

• In Steel Partners II, L.P. v. Point Blank Solutions, Inc., 2008 WL 3522431 (Aug. 12, 2008),  the initial complaint was filed to force the holding of a shareholders meeting (which had not taken place since 2005), pursuant to DGCL Section 211. After a stipulation was entered into for a date to hold the meeting, the defendant moved for leave of court to postpone the date of the meeting by 90 days. The Chancery Court denied the request. The request was based on allegations that the plaintiff and its CEO together own about 40% of the stock and would attempt to install their own directors and then seek to buy the company at the lowest possible price for its own investors. In addition, the postponement was requested due to an alleged conflict that the plaintiff's CEO had with the majority. The court reasoned that the best way to deal with the issues presented was to communicate them to the shareholders and let them decide, based on those facts, who they wanted as directors--instead of further delaying the exercise of the shareholder franchise, which under Delaware law is sacrosanct. The summary of the case on my blog is here.

• London v. Tyrrell, 2008 WL 2505435 (Del. Ch., June 24, 2008), read opinion here. This Chancery Court decision explained in detail the reasons why it denied a motion to dismiss a derivative claim based on Chancery Court Rules 9(b), 12(b)(6) and 23.1. The derivative complaint alleged that the defendants caused the company to issue stock options in contravention of an equity incentive plan by setting the exercise price of the issued options at an unfairly low value.After a thorough factual background description, the court emphasized that: “the burden remains on the movant to demonstrate that the plaintiff has not met the requirements of Rules 9(b), 12(b)(6) and 23.1." (see footnote 12). Moreover, the court described in detail the demand futility analysis under  the seminal case of Aronson v. Lewis, 473 A.2d 805 (Del. 1984) as well as Rales v. Blasband, 634 A.2d 927 (Del. 1993). The court explained the reasons why it concluded, as succinctly as I have seen it done, that both prongs of the Aronson case were satisfied. Specifically, the plaintiff demonstrated a reasonable doubt that: (1) the directors were interested and independent; or (2) the challenged transaction was otherwise the product of a valid exercise of business judgment.
  The first prong was satisfied because the directors had a financial interest in the challenged stock option plan and also because they stood on both sides of the transaction that was challenged. Moreover, the second prong was satisfied because the allegations rebutted the business judgment rule to the extent that the allegations supported an inference that the directors intended to violate the terms of a stockholder approved option plan. The court also dismissed the arguments under Rule 9(b) that there was insufficient particularity regarding fraud allegations which apparently relied on Sections 152 and 157(b) of the DGCL.

UPDATE: The Wall Street Journal online highlighted this post here. 

UPDATE II:   The Harvard Law School Corporate Governance Blog  published this post here.

UPDATE III:  Forbes. com  highlighted this post  here.

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In Re Lear Corp. Shareholder Litigation, 2008 WL 4053221 (Del. Ch., Sept. 2, 2008), read opinion here.

This is the third Chancery Court decision in about as many (business) days that addresses the issue of whether: claims against a board of directors will be dismissed based on the exculpation clause in a corporate charter as authorized by DGCL Section 102(b)(7). The results (if we were to use an analogy from sports) are: 2 to 1. That is, 2 cases involving such claims have been dismissed under Rule 12(b)(6) and 1 decision denied a motion for summary judgment filed by the board.

Two of the 3 cases I am referring to include: (i) the instant Lear case;  and (ii) the McPadden case of Aug. 29 summarized here. The other case I refer to  is the Ryan II decision also of Aug. 29 and summarized here.

A prior decision in this case, partially granting a motion for preliminary injunction, is summarized here. See In Re Lear Corp S'hlder Litig., 926 A.2d 92 (Del. Ch. 2007).

In some ways, this opinion is akin to a scholarly law review article with practical application that also includes a court decision (after a full recitation of the particlular facts of this case.)

There is so much that can be written about this case, but let's start with a few basics. The primary complaint was that the board agreed to a termination fee of $25 million (less than 1% of the transaction price) in exchange for an increase in the purchase price by the winning bidder for the sale of the company. The plaintiffs claimed that the board knew that the shareholders would most likely not approve the merger and, therefore, by agreeing to pay a termination fee simply upon a "no vote" by the shareholders,  they breached their fiduciary duties.

The court summarized its reasoning thusly:

"Directors are entitled to make  good faith business decisions even if the stockholders might disagree wth them. Where, as here, the complaint itself indicates that an independent board majority used an adequate process, employed reputable financial, legal and proxy solicitation experts, and had a substantial basis to conclude a merger was financially fair, the directors cannot be faulted for being disloyal simply because the stockholders ultimately did not agree with the recommendation. In particular, where, as here, the directors are protected by an exculpatory charter provision, it is critical that the complaint plead facts suggesting a fair inference that the directors breached their duty of loyalty by making a bad faith decision to approve the merger for reasons inimical to the interests of the corporation and its stockholders. Where a complaint, as here, does not even create an inference of mere negligence or gross negligence, it certainly does not satisfy the far more difficult task of stating a non-exculpated duty of loyalty claim."

Although this case started out asserting Revlon claims and proxy disclosure frailties, after the merger was voted down, those claims were dismissed as moot. (Curiously, with Lear's stock now trading at about $13, the shareholders now wish they would have had voted for the offer at $37.25 per share.)

Aronson and Section 102(b)(7)

The plaintiffs skipped any attempt to satisfy the first prong of the Aronson test, and instead attempted to satisfy the second prong of Aronson by attempting to state particularized facts to establish a non-exculpated breach of fidcuicary duty by the Lear board.

Because the Lear charter contains an exculpatory provision under DGCL Section 102(b)(7), the plaintiffs cannot sustain their complaint even by pleading facts supporting an inference of gross negligence.     (continued below)

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