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

Robotti & Co. LLC v. Liddell, No. 3128-VCN (Del. Ch., Jan. 14, 2010), read opinion here. See summary of Court of Chancery's prior Section 220 decision involving these parties here.

This 43-page Delaware Court of Chancery decision could serve as a “mini-law review article” that explains the current Delaware law on a wide range of issues important to those involved in corporate derivative litigation, and directors who want to understand the standards by which their conduct will be reviewed by the courts.

Background

The factual and procedural background of this matter is that it is a class and derivative action challenging a stockholder rights offering ("Offering"). The shareholder plaintiff alleges that the directors of the company set the Offering at a deliberately and inadequately low price that would trigger anti-dilution provisions in the agreements governing the stock options and warrants of the controlling shareholder. The shareholder plaintiffs argued that the triggering of the anti-dilution provisions resulted in a benefit being enjoyed by the directors that was not shared by the other shareholders and therefore, was a self-dealing transaction. The Court found, however, that the complaint failed to state a claim because the anti-dilution provisions did not change or challenge the pre-existing contractual rights of the directors which left them in substantially the same position they were in before the rights Offering. Thus, the shareholder did not sufficiently allege disloyal conduct by, for example, showing that the directors acquiesced  to the wishes of the controlling shareholder.

This cursory review will simply highlight key aspects of the Court’s opinion so that the interested reader can decide to review the full text of the decision on their own at the above link.

Court’s Summary of Issues in Case and Its Four-Part Holding

The Court described this case as one that “ultimately boils down to an alleged breach of the duty of loyalty and whether or not the defendants obtained a personal benefit through the Offering.” The Court’s reasoning and analysis can be summarized in four parts: (1) The Court cannot draw a reasonable inference from the facts that the Offering’s trigger of the anti-dilution provisions and their effect upon the options worked a material personal gain to the directors at the expense of the public stockholders. Nor did the plaintiff plead sufficient facts to support a claim that the directors acted in bad faith by consciously disregarding their fiduciary duties. (2) Because the court cannot reasonably infer from the facts that the directors received a personal gain by way of the collateral consequences of the Offering or consciously disregarded their duties, their decision to consummate the Offering is protected by the business judgment rule. (3) Of equal importance, the plaintiff has not duly alleged that the controlling shareholder dominated the board as it approved the Offering. (4) The derivative claims were barred because the plaintiff failed to plead that the board of directors were either interested or under the control or domination of an interested party as of the time it asserted the derivative claims.

Court Declines to Convert Motion to Dismiss into Motion for Summary Judgment

Robotti requested that the Court treat the motion to dismiss by the defendants as one for summary judgment because the defendants relied upon documents that were neither integral to, nor incorporated within, the complaint. The Court declined the invitation to treat the motion as one under Rule 56 as opposed to Rule 12(b)(6), which would have given the parties a reasonable opportunity to present all material relevant to a summary judgment motion. The Court observed that matters beyond the complaint may generally not be considered in a ruling on a motion to dismiss except in the following instances: “(1) When such documents are integral to, and incorporated within, the plaintiff’s complaint; or (2) When the documents are not being relied upon for the truth of their contents.” See footnote 49.

Direct v. Derivative Claims 

The opinion contains a thorough discussion and analysis of the differences between a direct as compared to a derivative claim. Referring to recent Delaware Supreme Court opinions on the topic, the Court explained that an initial inquiry in determining between a direct and derivative claim requires the following two questions to be addressed: “(1) Who suffered the alleged harm - - the corporation or the shareholders individually; and (2) Who would receive the benefit of the recovery or other remedy?” See footnotes 55 and 56.

The Court discussed the recent cases that have analyzed whether a dilution in the value of corporate stock and overpayment by fiduciaries is direct or derivative. The recent decision in Gentile v. Rossette, 906 A.2d 91 (Del. 2006) was described as involving a controlling shareholder who caused the company to issue the controlling shareholder’s stock in return for debt forgiveness. The Supreme Court in Gentile held that both the corporation and the shareholders were harmed by the overpayment and due to the dual nature of the harm, the claims in that class were both derivative and direct.

Analysis of Bad Faith and Breach of Duty of Loyalty Claims

The Court described a methodology for analyzing allegations of bad faith within the context of a duty of loyalty claim as being recently clarified by the Delaware Supreme Court in Lyondell Chemical Co. v. Ryan, 970 A.2d 235 (Del. 2009). The Court of Chancery explained as follows:

“Mere gross negligence, which includes the failure to inform oneself of available material facts, cannot constitute bad faith. Bad faith, and thus a breach of the duty of loyalty, can arise only when a fiduciary consciously disregards his or her responsibilities. The Court in Lyondell imposed a high standard on any plaintiff advancing such a claim, and recognized a “vast difference between an inadequate or flawed effort to carry our fiduciary duties and a conscious disregard of those duties.” It concluded that fiduciaries in this context breached their duty of loyalty only if they “knowingly and completely fail to undertake their responsibilities.”

In this case, the Court found that Robotti never claimed that the defendants “knowingly and completely” failed to undertake their responsibilities, nor may any such inference be drawn from the complaint.

Business Judgment Rule Applies

This opinion provides a robust discussion of the business judgment rule, its applicability, and the pleading requirements under Rule 23.1.

Notably, this is the first Delaware decision that cites to the current version of the highly regarded four volume treatise on the business judgment rule recently published by Stephen A Radin and which is cited at footnote 89 by the Court as follows: 1 Stephen A. Radin, et al., The Business Judgment Rule: Fiduciary Duties for Corporate Directors 110 (6th ed. 2009).

Referring to the Radin treatise, the Court defines the business judgment rule as follows:

“The business judgment rule, as a general matter, protects directors from liability for their decisions so long as there exists a ‘business decision, disinterestedness and independence, due care, good faith and no abuse of discretion and a challenged decision does not constitute fraud, illegality, ultra vires conduct or waste.’ There is a presumption that directors have acted in accordance with each of these elements, and this presumption cannot be overcome unless the complaint pleads specific facts demonstrating otherwise. Put another way, under the business judgment rule, the Court will not invalidate a board’s decision or question its reasonableness, so long as its decision can be attributed to a rational business purpose.” See footnote 91.

The Court found that Robotti had been unable to allege that defendants were interested in the transaction and it also failed to allege bad faith or conscious disregard of fiduciary duty. Moreover, although Robotti may have plead a failure to act with due care and on an informed basis regarding the transaction, such a conclusion would be unhelpful in light of the provision in the charter pursuant to Section 102(b)(7) which would preclude a claim for damages on that ground.

Demand Excusal

The Court also conducted an analysis under Rule 23.1 and found that the derivative claims did not satisfy that rule. Footnote 95 and 96 made it clear that the applicable time period to determine whether the pre-suit demand requirement was futile was when the first derivative claim was presented--which was in the second amended complaint. The composition of the Board at that time when the first derivative claim was filed made the Rales v. Blasband case applicable. See 634 A.2d 927, 933-34 (Del. 1993). Under Rales, the Court explained that the relevant inquiry is only whether the board can exercise its independent and disinterested judgment in responding to a demand, where, as here, the majority of the directors responsible for that decision have since been replaced.

Definitions to Determine "Interested" or "Independent" Directors

The Court provides a helpful discussion and definition of the term “interested” for purposes of pre-suit demand upon the board. Likewise for pre-suit demand purposes, the Court provides a useful definition to determine whether a director is "independent" for purposes of a pre-suit demand analysis. See footnote 98: “The mere fact that a director receives some benefit that was not shared generally by all shareholders is insufficient; the benefit must be material.”

For purposes of demand excusal analysis, rather, the plaintiff must show that the alleged benefit was “significant enough in the context of the director’s economic circumstances, as to have made it improbable that the director could perform her fiduciary duties to the . . . shareholders without being influenced by her overriding personal interest.” See footnote 99.

Regarding the independence of a director, the Court emphasized the contextual aspect of the inquiry, which requires a Court to ask “whether the directors are so ‘beholden’ to an interested director or interested controlling shareholder, that ‘their discretion would be sterilized.’ Motivations such as friendship may influence the inquiry, but in order for friendship alone to neutralize the independence of a director, the ‘relationship must be of a bias-producing nature.’” See footnote 101.

The Delaware Supreme Court has required that a complaint identify a relationship between a disinterested director and the interested director or controlling shareholder “that is so close that one could infer that the ‘non-interested director would be more willing to risk his or her reputation than risk the relationship with the interested director.’” See footnote 103.

The Court analyzed the factual situation as it related to each board member at the time the derivative claim was made in the second amended complaint, and found that the complaint did not adequately justify excusal of a pre-suit demand.

Conclusion

Thus, because the Court found that a majority of the board at the time of the derivative claim was both independent and disinterested, Robotti did not sufficiently plead demand futility and to that extent his derivative claims were dismissed. In addition, the claim for self-dealing by interested fiduciaries failed as a matter of law and the facts did not support an inference that the directors consciously disregarded their fiduciary duties or entirely abdicated their responsibilities. Therefore, the complaint was dismissed.

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Professor Bainbridge provides scholarly commentary here on the recent Chancery Court decision in Citigroup, including a rebuttal to Professor Jay Brown and an analysis of Caremark duties, as well as a discussion of the theoretical and practical underpinning of the Business Judgment Rule.

My prior highlighting of the Citigroup case and a link to the actual opinion is here.

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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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In Re: Affiliated Computer Services, Inc. Shareholders Litigation,  (Del. Ch., February 6, 2009), read opinion here.

We are fortunate to have the following review and analysis of this case prepared by Kevin Brady,  a partner in the Business Law Group at the Wilmington, Delaware, office of Connolly Bove.  

In a dispute involving yet another victim of the credit crisis, the Court of Chancery dismissed a second amended complaint in a derivative suit arising out of the failed bid by Cerebus Capital Management LP (“Cerebus”) and Affiliated Computer Services Ins (“ACS”) to take ACS private.   On February 6, 2009, Vice Chancellor Stephen P. Lamb dismissed the action after he found that: (i) the majority of the ACS board was independent; (ii) the directors had not breached their fiduciary duties to the ACS’ shareholders; and (iii) demand had not been excused.

Background

In late 2005, ACS received an unsolicited buyout offer of $65 per share from a consortium of large private equity firms. While ACS rejected the offer, it stated that it was “continuing to consider additional alternatives for enhancement of shareholder value, but [those] alternatives do not include a sale of the Company.” On November 7, 2006, Darwin Deason, founder, chairman and significant stockholder of ACS, working with unnamed private equity sponsors, sent a buy-out proposal in the range of $60 to $62 per share to the ACS board, telling the board that he did not intend to vote his shares in favor of, or otherwise participate in, any transaction with a party other than his group.

At a special meeting of the board on November 9, 2006, Deason recommended that, among other things, his two potential private equity sponsors be permitted to engage in due diligence for two to three-weeks with ACS. The board ultimately agreed to a three-week due diligence process. On March 20, 2007, Deason and Cerberus (the “Buyout Group”) announced a proposal to acquire all of the outstanding stock of ACS (except for those shares owned by Deason and the company’s management team) for $59.25 per share in cash. Also on March 20, 2007, the ACS board held a special meeting and thereafter formed a special committee. On April 21, 2007, the Buyout Group raised its offer to $62 per share with a provision that there be a 40-day “go shop” period following the signing of a definitive merger agreement between ACS and the Buyout Group. On April 23, 2007, the special committee responded in a letter to Deason in which the special committee expressed its misgivings and “serious concerns” with regard to the company’s ability to attract other bidders during a “go shop” period given Deason’s five-year employment agreement, exclusivity agreement with Cerberus, and the head start that Cerberus had with respect to due diligence. On June 10, 2007, ACS and Cerberus executed a waiver pursuant to which Deason would be permitted to engage in discussions with potential bidding parties other than Cerberus. In exchange for this waiver, ACS agreed to pay Cerberus $7.5 million in compensation for its expenses incurred in connection with the buyout proposal.

After the credit crisis hit in the summer of 2007, the deal fell apart and on October 30, 2007, Cerberus withdrew its buyout offer. Thereafter, Deason accused all of the outside directors of ACS of various breaches of fiduciary duty, and demanded their resignation.

The outside directors responded by filing suit against Deason, the management directors and ACS on November 1, 2007, seeking a declaratory judgment that they had not breached their fiduciary duties. On November 21, 2007, the outside directors dismissed their complaint pursuant to a settlement agreement, resigned from the board and issued a statement that they were satisfied that the replacement director candidates were qualified and independent of Deason and the company’s management.

The complaint, which was filed on March 22, 2007 as a purported class action on behalf of the stockholders of ACS, challenged the buyout proposal made by Deason. When Cerberus withdrew its buyout proposal on October 30, 2007, the claims for injunctive relief in the complaint were effectively mooted. As a result, the plaintiffs file their first amended complaint on November 5, 2007 and asserted derivative claims for the first time, while continuing to plead their class claims in the alternative. On December 19, 2007, various defendants filed motions to dismiss the first amended complaint. In lieu of filing answering briefs to the motions to dismiss, the plaintiffs filed a consolidated second amended class and derivative action complaint which essentially supplemented the fact allegations in the first amended complaint. No new counts were added and the fundamental nature of the allegations remained unchanged. The claims alleged in the second amended complaint, like those in the first amended complaint, were based on the abandoned buyout process. Following the plaintiffs’ filing of the second amended complaint, the defendants renewed their various motions to dismiss for failure to make demand pursuant to Rule 23.1 and failure to state a claim pursuant to Rule 12(b)(6).

Demand Futility and the Amended Complaint

Under Delaware law, unless the plaintiffs can show futility, they must make a demand on the board of directors before a derivative action may be instituted on behalf of the corporation. The Court in this case was faced with two issues:

(i) against which board is the claim of demand futility to be tested–the old board that was still in office on November 5, 2007, or the new board that was in office at the time of the filing of the second amended complaint; and

(ii) if it is the new board, are the claims presented by the second amended complaint already “validly in the litigation”?

The Court found that the plaintiffs had made no allegations of demand futility with respect to the new board and so, if the complaint were to survive the motion to dismiss, the plaintiffs had to prove that demand futility should be tested with respect to the old board. As a result, the Court turned to the second issue -- what it means for a claim to be “validly in litigation.

” Under Delaware law, there are three circumstances that must exist in order to excuse a plaintiff from showing demand futility as of the time of filing the amended complaint: (1) “the original complaint was well pleaded as a derivative action;” (2) “the original complaint satisfied the legal test for demand excusal;” and (3) “the act or transaction complained of is essentially the same as the act or transaction challenged in the original complaint.” The first and third prongs of the test were not contested by the parties so the Court focused on the second prong.

Demand is excused under Aronson and its progeny if either prong of a two-part test is met:

(i) whether a reasonable doubt is created that the directors are disinterested and independent; and (ii) whether the pleading creates a reasonable doubt that the challenged transaction was anything other than the product of a valid exercise of business judgment.

Disinterested and Independent

Directors will be deemed interested for demand purposes under Aronson where the complaint alleges specific facts establishing that “the potential for liability is not ‘a mere threat’ but instead may rise to ‘a substantial likelihood.’” Simply being named as a defendant is not enough.  “Independence means that a director’s decision is based entirely on the merits of the subject before the board rather than extraneous considerations or influence.” Vice Chancellor Lamb, in analyzing the first amended complaint to determine if it adequately plead demand futility with respect to the board as it existed at the time the amended complaint was filed, found that the plaintiffs had pled nothing to suggest that the outside directors had any financial interest in the proposed transaction beyond their interest as stockholders.

The plaintiffs, however, did raise a novel issue -- can a board in the midst of internal warfare, with the majority of its members preparing to resign, be expected to properly consider a stockholder demand? The Court found that the analysis focuses on whether the majority of the board could fairly be said to have abandoned their duties, such that making a demand upon them would be futile. In this instance, before tendering any resignation, the outside directors insisted on passing on the qualifications of their replacements, to ensure that the board would remain with a majority of independent directors in order to protect the minority stockholders.

Business Judgment Rule

The Court then turned to the second prong of Aronson and found that the plaintiffs failed to plead any facts to undermine the presumption that the outside directors of the board, and in particular the special committee, failed to fully inform themselves in deciding how best to proceed to get out from under the exclusivity agreement and attempt to run a robust sale process. Nor did the complaint challenge to the board’s or the special committee’s good faith in pursuing the course it chose in dealing with Deason. The plaintiffs simply argued that they “would have run things differently.” As a result, the Court found that the business judgment rule had not rebutted.

Demand Not Excused – Second Amended Complaint Dismissed

The Court concluded that the plaintiffs failed to plead facts in the first amended complaint that raised a reasonable doubt under either prong of Aronson. The derivative claims in the first amended complaint were therefore not validly in litigation when the plaintiffs amended their complaint the second time. Thus, the plaintiffs were required to either make a demand at the time they filed their second amended complaint, or to plead that a demand would be futile at that time, and therefore excused. Because plaintiffs failed to do so, Vice Chancellor Lamb concluded that pre-suit demand on the board of directors of ACS was not excused and the second amended complaint was dismissed.

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In Gantler v. Stephens, (Del. Supr., Jan. 27, 2009), read opinion here, the Delaware Supreme Court, yesterday,  issued a major decision on important matters of Delaware corporate law. Delaware's High Court  for the first time confirmed and clarified that officers of Delaware corporations have the same fiduciary duties as directors of Delaware corporations.

In addition, the Delaware Supreme Court clarified and enunciated Delaware common law on the issue of  "shareholder ratification".

In a rare reversal of the Chancery Court,  the Supreme Court determined that the breach of fiduciary duty claims in this case should be allowed to proceed, and explained why the board should not enjoy the presumption of the business judgment rule at this stage of the proceedings,  based on the pled facts (contrary to the Chancery Court's dismissal of the case, based on an earlier opinion summarized here.)

 The Supreme Court's own succinct  introductory summary to its opinion follows:

The plaintiffs in this breach of fiduciary duty action, who are certain shareholders of First Niles Financial, Inc. (“First Niles” or the “Company”), appeal from the dismissal of their complaint by the Court of Chancery The complaint alleges that the defendants, who are officers and directors of First Niles, violated their fiduciary duties by rejecting a valuable opportunity to sell the Company, deciding instead to reclassify the Company’s shares in order to benefit themselves, and by disseminating a materially misleading proxy statement to induce shareholder approval. We conclude that the complaint pleads sufficient facts to overcome the business judgment presumption, and to state substantive fiduciary duty and disclosure claims. We therefore reverse the Court of Chancery’s judgment of dismissal and remand the case for further proceedings consistent with this Opinion.

 The distilled essence of the factual genesis of this case is the decision of the Board of First Niles Financial  to sell itself, but thereafter not taking seriously three offers that it received, and instead appearing to favor a privatization or a reclassification plan. The three basic claims in the complaint were that the board members breached their fiduciary duties to the First Niles shareholders by rejecting an offer from a potential buyer and abandoning the sale of the company.  Secondly, the claim was that the defendant directors breached their fiduciary duty of disclosure by disseminating a materially false and misleading proxy regarding the reclassification. Third, the amended complaint alleges that it was a breach of fiduciary duty to implement the reclassification plan.

The Chancery Court dismissed the amended complaint, ruling that it failed to allege facts that were sufficient to overcome the presumption of the business judgment rule and for failing to establish that the proxy was materially false and misleading, as well as based on the argument that the shareholders “ratified “ the decision of the board to reclassify the shares.

The Supreme Court reviewed the trial court’s grant of the motion to dismiss on a “de novo basis”  to determine whether “the trial judge erred as a matter of law in formulating or applying legal precepts.”

Although Count I of the complaint alleged that the directors breached their duties of loyalty and care by abandoning the sale of the bank in order to retain the benefits of incumbency, the trial court concluded that the Unocal  standard did not apply because the complaint did not allege any “defensive” action by the board. The trial court also determined that the entire fairness review was not applicable because the board did not interpose itself between the shareholders and a potential acquirer by means of defensive measures, and thus  the trial court applied the business judgment standard and concluded that the allegations in the complaint failed to rebut the presumption of business judgment.

The Supreme Court upheld the Chancery Court’s refusal to apply the Unocal standard because the essence of the transaction at issue was not defensive and the initial count in the complaint was based on disloyalty as opposed to defensive conduct. Nor does Count I allege any hostile takeover attempt or similar threatened external action from which it could be inferred that the defendants acted defensively, despite the allegation that they improperly delayed or sabotaged the due diligence process.

The Business Judgment Rule

Next, the Supreme Court addressed whether the trial court appropriately found that the plaintiff did not satisfy the burden of pleading facts sufficient to rebut the presumption of the business judgment rule that  “in making a business decision the directors of a corporation acted on an informed basis, in good faith and in the honest belief that the action taken was in the best interest of the company.” (citing Aronson v. Lewis, 473 A.2d 805, 812 (Del. 1984)).

Delaware’s High Court recognized that a board is generally entitled to the presumption of the business judgment rule in declining a merger opportunity because implicit in the statutory authority of the board to propose a merger, is also the power to decline a merger.

In order to determine whether the board merits the business judgment presumption, the court makes a two-part analysis. First, did the board reach its decision in the good faith pursuit a legitimate corporate interest. Second, did the board do so advisedly (see footnotes 29 to 31).

The first prong of the analysis requires that the duty of loyalty be examined. In this case, the plaintiff alleges that the directors had a disqualifying self-interest because they were financially motivated to maintain the status quo and to keep their current positions. The Supreme Court was wary of such an argument which it recognized to be tautological, to some extent, because a board decision to reject a merger proposal could always enable plaintiff to assert that a majority of the directors had an entrenchment motive. For that reason, the court explained that in addition to that argument, other facts that support a disloyal motive must be stated.

The Supreme Court determined that a sufficient showing to establish disloyalty at least at this early procedural stage was demonstrated. The court reasoned that the pled facts were sufficient to establish the disloyalty of at least three of the directors, which suffices to rebut the business judgment presumption because in this case three of the directors constituted a majority. Also, for purposes of Rule 12(b)(6) there was a sufficient “director-specific analysis” to demonstrate that a majority of the board was conflicted based on specific alleged conduct from which a duty of loyalty violation can reasonably be inferred. The court recites in detail in its opinion specific facts about each individual director and why such allegations support a conflict.

Officers Share Same Fiduciary Duties as Directors

Importantly, in this decision, the Delaware Supreme Court for the first time explicitly holds, what has been implicitly stated previously and has been also acknowledged by the Delaware Chancery Court, and that is: “officers of Delaware corporations, like directors, owe fiduciary duties of care and loyalty, and the fiduciary duties of officers are the same of directors.” (See footnote 36, but also note footnote 37 which acknowledges that DGCL Section 102(b)(7) does not exculpate officers from liability for breaches of their duty of care in the current statutory provision.)

On the issue of whether a delay in the due diligence process was a breach of the fiduciary duty of the directors, the Supreme Court disagreed with the trial court. The Supreme Court explained that  on a motion to dismiss, the trial court is “not free to disregard that reasonable inference, or to discount it by weighing it against other, perhaps contrary inferences that might also be drawn,” making reference to the decision of the trial court that a delay of a couple of weeks could not be the basis for a breach of fiduciary duties.

Disclosure Violations Held Material

In addition, the Supreme Court determined that the proxy disclosures concerning the deliberations of the board about the offer that was rejected, were materially misleading. The court reviewed the materiality standard and reached a different conclusion than the trial court, thus allowing that claim to proceed.

Duty of Loyalty Claim Allowed to Proceed

Lastly, the Supreme Court also reversed the trial court’s decision on Count III of the complaint which alleged that the directors breached their duty of loyalty by recommending the reclassification proposal to shareholders for purely self-interested reasons (that is, to enlarge their ability to engage in stock buy-backs and to trigger appraisal rights). The Supreme Court reasoned that the trial court’s ruling on “shareholder ratification grounds” was in error for two reasons. First, because a shareholder vote was required to amend the certificate of incorporation, without the approving vote it could not operate to “ratify” the challenged conduct of the interested directors. Second, the claim that the reclassification proxy contained a material misrepresentation, eliminates the essential prerequisite for applying the ratification doctrine, namely, that the shareholder vote was fully informed.

Common Law Shareholder Ratification Doctrine Clarified and Enunciated

The Supreme Court recognized that the current scope and effect of the common law doctrine of “shareholder ratification”  in Delaware is unclear. Thus, in order to

“restore coherence and clarity to this area of our law, we hold that the scope of the shareholder ratification doctrine must be limited to its so-called ‘classic’ form; that is, to circumstances where a fully informed shareholder vote approves director action that does not legally require shareholder approval in order to become legally effective. Moreover the only director action or conduct that can be ratified is that which the shareholders are specifically asked to approve. With one exception, the “cleansing” effect of such a ratifying shareholder vote is to subject the challenged director action to business judgment review, as opposed to “extinguishing” the claim altogether (i.e., obviating all judicial review of the challenged action.) " 

(emphasis in italics and underlining are mine)(See footnotes 52 through 54 for supporting citations).

Moreover, yet another major judicial statement in this opinion is contained in footnote 54. Referring to the last sentence in the foregoing block quote, footnote 54 states that “to the extent that Smith v. Van Gorkom holds otherwise, it is overruled.” (488 A.2d 858, 889-90 (Del. 1985)). Of special note in footnote 54 also is the clarification that the references in this opinion only refer to the common law  doctrine of shareholder ratification and are not intended to alter the jurisprudence governing the approving vote of disinterested shareholders pursuant to Section 144 of the Delaware General Corporation Law.

Much more can be written, and much more will be written, about this very momentous decision that announces very substantial clarifying statements of Delaware corporate law. This summary is already longer than most blog posts but I look forward to linking to additional scholarly commentary by others.
UPDATE: Prof. Usha Rodrigues on The Conglomerate blog comments on the case here and  she links to her own article on the topic as well as to seminal writings on the issue by Prof. Lyman Johnson here.   The Unincorporated Business Law Prof Blog comments on the case here. Also,  Prof. Lawrence Cunningham on the Concurring Opinions blog comments, with some aggregation of other remarks about the case, here.

UPDATE II: Here is a post about the opinion on DealLawyers Blog which agrees it is an important decision.

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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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Courtesy of Professor Bainbridge is a link to an article by Professor Bob Thompson on the seminal  Delaware Supreme Court decision in Sinclair Oil v. Levien, from 1971, that addressed key issues of fiduciary duty and judicial review standards. Here is an excerpt from a quote that Professor B. included in his post about the article.

Sinclair provides room for “selfish” ownership for a majority shareholder, so long as the minority shareholders receive a proportional benefit, a standard that at the time seemed to expand the discretion for majority shareholders. Viewed from a point decades later, this part of Sinclair has not proved to be a template for broader applications and other doctrines have developed to constrain the actions of majority shareholders.

Keywords: director action, judicial review of corporate action, business judgment rule, intrinsic fairness, enhanced scrutiny, controlling shareholders, fiduciary duty

UPDATE: Here is an insightful analysis by Professor Larry Ribstein of the Sinclair case highlighted in Professor  Thompson's article. A quote  from Professor R's extensive discussion of the "contract aspect of the case"  follows:

Once you’re outside of fiduciary land, as you are in Sinclair, parties in a commercial relationship can act selfishly to each other, governed by their contracts. Sometimes the contract is implied and not obvious. But the court should look hard for these contractual guideposts. The fog of fiduciary language often obscures the search. This is the basic lesson of Sinclair

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CA, Inc. v. AFSCME Employees Pension Plan, (Del. Supr., July 17, 2008), read opinion here.(Revised opinion dated August 15, 2008, available here.)

This Delaware Supreme Court  decision has been anticipated by the corporate legal world with great interest since oral arguments were heard by Delaware's High Court last week.  My post with some background can be found here.  More background discussion of prior Delaware decisions that have addressed related issues, as provided by Professor Bainbridge, can be found here.

In sum, a shareholder of CA, Inc., the trillion dollar pension fund of AFSCME, proposed a bylaw amendment that would require the company to reimburse the shareholder for expenses related to nominating a less than full slate to the board of directors.

Here are the two issues presented by the SEC to the Delaware Supreme Court in a procedure authorized last year and now used for the first time:

1. Is the AFSCME Proposal a proper subject for action by shareholders as a matter of Delaware law?

2. Would the AFSCME Proposal, if adopted, cause CA to violate any Delaware law to which it is subject?

Bottom line of the decision: Yes and yes. Although bylaws, in general,  are permissibly used to address the process and procedures related to board elections, in the particular circumstances of this case, the bylaw proposed would impermissibly restrict the managerial and fiduciary duties of the board. However, the court suggested other means by which the shareholder could achieve the same goal in a way that would be consistent with Delaware law: for example, amend the certificate of incorporation.

 Here is the court's reasoning, in part, for its affirmative answer to the first question:

The shareholders of a Delaware corporation have the right “to participate in selecting the contestants” for election to the board. The shareholders are entitled to facilitate the exercise of that right by proposing a bylaw that would encourage candidates other than board-sponsored nominees to stand for election. The Bylaw would accomplish that by committing the corporation to reimburse the election expenses of shareholders whose candidates are successfully elected. That the implementation of that proposal would require the expenditure of corporate funds will not, in and of itself, make such a bylaw an improper subject matter for shareholder action. Accordingly, we answer the first question certified to us in the affirmative.

That, however, concludes only part of the analysis. The DGCL also requires that the Bylaw be “not inconsistent with law.” Accordingly, we turn to the second certified question, which is whether the proposed Bylaw, if adopted, would cause CA to violate any Delaware law to which it is subject. (footnotes omitted).

For its affirmative answer to the second question, the court provided the following reasoning:

... the Bylaw mandates reimbursement of election expenses in circumstances that a proper application of fiduciary principles could preclude. That such circumstances could arise is not far fetched. Under Delaware law, a board may expend corporate funds to reimburse proxy expenses “[w]here the controversy is concerned with a question of policy as distinguished
from personnel o[r] management.” But in a situation where the proxy contest is motivated by personal or petty concerns, or to promote interests that do not further, or are adverse to, those of the corporation, the board’s fiduciary duty could compel that reimbursement be denied altogether.

It is in this respect that the proposed Bylaw, as written, would violate Delaware law if enacted by CA’s shareholders. As presently drafted, the Bylaw would afford CA’s directors full discretion to determine what amount of reimbursement is appropriate, because the directors would be obligated to grant only the “reasonable” expenses of a successful short slate. Unfortunately, that does not go far enough, because the Bylaw contains no language or provision that would reserve to CA’s directors their full power to exercise their fiduciary duty to decide whether or not it would be appropriate, in a specific case, to award
reimbursement at all. (footnotes omitted)

Footnote 14 which directly addresses the issue of:  "what is the scope of shareholder action that Section 109(b) permits [regarding bylaws] yet does not improperly intrude upon the directors’ power to manage a corporation’s business and affairs under Section 141(a),"   explains exactly what the court did--and did not--decide:

 We do not attempt to delineate the location of that bright line in this Opinion. What we do
hold is case specific; that is, wherever may be the location of the bright line that separates the shareholders’ bylaw-making power under Section 109 from the directors’ exclusive managerial authority under Section 141(a), the proposed Bylaw at issue here does not invade the territory demarcated by Section 141(a).

One of the great things about covering this area of the law on this blog is that many experts in the field cover the same issues, so I can link to their scholarly analysis as a supplement (and sometimes in place of) any comments I have. A few samples of the corporate law professors who have already provided scholarly analysis of this opinion within hours of its release, are: here, here, here, here and here.

 I invite readers to tell me if they are aware of any other state's highest court that can be counted on, predictably, to render such a weighty decision within a week of hearing oral argument--and when the briefs were only submitted a mere two (2) days prior to oral argument.
 

UPDATE: As one would expect, an enormous amount of high quality commentary continues apace in the blogosphere about this case, and I may update this post or supplement it in the coming days. Also, as an aside, perhaps I will never get accustomed to it, as I am still thrilled when one of my posts is quoted by a luminary like Professor Bainbridge, as he was kind enough to do today here.

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