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

In two actions involving challenges to a consummated acquisition, the Court of Chancery in In re Nymex Shareholder Litigation, Nos. 3621-VCN, 3835-VCN and Greene v. New York Mercantile Exchange, Inc., et al., No. 3835-VCN (Del. Ch. Sept. 30, 2009), read opinion here, dismissed a multitude of conclusory allegations regarding breaches of fiduciary duties of loyalty, due care and candor in the sale of NYMEX to CME. In doing so, the Court reaffirmed the considerable deference Delaware law provides to an independent Board facing a change of control situation post-Lyondell.

Kevin Brady, a highly respected Delaware litigator, prepared this synopsis.

The Merger

NYMEX “was the largest commodity futures exchange in the world.” The defendants were all members of the Board of Directors of NYMEX including Richard Schaeffer (chairman of NYMEX) and James Newsome (President and Chief Executive Officer). The Plaintiffs consisted of common stock owners (the “NYMEX Plaintiffs”) and Shelby Greene who brought an action on behalf of the Class A Members of the NYMEX Exchange.

In the middle of 2007, the NYMEX Board established a Strategic Initiatives Committee (“SIC”) in order to “consider, negotiate and recommend any significant transaction involving NYMEX.” At about the same time, New York Stock Exchange (“NYSE”) Chairman John Thain spoke with Schaeffer about NYSE purchasing NYMEX for $142 per share, which represented a large premium above NYMEX’s then trading price. However, NYSE never made a formal offer allegedly because “Schaeffer personally demanded a senior executive position for himself as a pre-condition of the deal.”

Prior to Thain’s expression of interest, Schaeffer and Newsome had initiated negotiations between NYMEX and CME and at the beginning of 2008, a confidentiality agreement was entered into between the two companies. After the confidentiality agreement was announced, the NYMEX Board approved a change of control severance plan “which provided more than $97 million in change of control payments to senior management.”

Three weeks later, NYMEX announced that “CME had offered to buy NYMEX for approximately $119 per share, which represented a 2.1% premium over the closing price of NYMEX shares on that day and an 11% premium above the closing price of NYMEX shares on the last trading day prior to the announcement. . . . [and that a] substantial portion of the merger consideration was payable in CME stock.” NYMEX also announced that it had entered into a 30-day exclusive negotiating period with CME which was later extended to March 15, 2008.

No Collar Negotiated; No Protection Against Drop in Share Price

Prior to the announcement, CME stock was trading at $635.14 per share, but within a week of the announcement it fell to $485.25 per share. Notably, the CME offer did not contain a collar, which would have provided protection against fluctuations in stock price. As a result of the lack of a collar and because much of the merger consideration was in CME stock, the decline in stock price resulted in a substantial decline in the merger consideration. According to the Complaint, CME offered to “collar” the stock portion of the merger consideration but that offer was rejected by Schaeffer and Newsome (although they supposedly never mentioned the offer of a collar to the rest of the Board).

On March 17, 2008, CME and NYMEX announced the merger agreement, consistent with the original offer in January 2008, by which CME agreed “to acquire all of NYMEX’s common stock in exchange for $36 per share in cash and 0.1323 shares of CME common stock per NYMEX share.” By this date, the merger consideration had fallen to $100.30 per share. Nonetheless, J.P. Morgan and Merrill Lynch provided fairness opinions in favor of the deal. The Board unanimously approved the merger and more than 95% of the shares were voted in favor of the deal. The merger closed on August 22, 2008.

Plaintiffs’ Allegations

Plaintiffs in the NYMEX action brought numerous allegations of breaches fiduciary duties of loyalty, due care and candor arising out of the sale of NYMEX to CME. Plaintiffs also alleged that the Board was controlled by Schaeffer, and that the Board agreed to sell NYMEX through an unfair process at an inadequate price in order for Schaeffer and Newsome to obtain nearly $60 million in severance payments. Further, the shareholder class alleged that the directors breached their fiduciary duties by, among other things:

• omitting or misstating necessary information in NYMEX’s proxy materials with respect to the CME deal;

• agreeing to CME’s first and only offer;

• failing to inquire into other potential transactions;

• agreeing to a 30-day exclusive negotiating period with CME;

• causing investment bankers to allegedly understate the value of NYMEX shares in fairness opinions supporting the transaction;

• agreeing to a $50 million breakup fee; and

• agreeing to the $97 million change in control plan with an acquisition agreement imminent.

Plaintiffs also asserted that the CME Defendants aided and abetted the NYMEX Defendants in the breach of the above duties.

Does Revlon “Change of Control” Scrutiny Apply to Mixed Cash/Stock Deals?

The parties disputed whether this case should be evaluated under Revlon, Inc. v. MacAndrews & Forbes Holdings, Inc., as involving a fundamental change of corporate control or whether it should be evaluated under the business judgment rule. While “Revlon scrutiny applies only to transactions ‘in which a fundamental change of corporate control occurs or is contemplated,’ such ‘change of control’ does not occur for purposes of Revlon where control of the corporation remains, post-merger, in a large, fluid market.”

“In transactions . . . that involve merger consideration that is a mix of cash and stock,” the Court noted that “[t]he [Delaware] Supreme Court has not set out a black line rule explaining what percentage of the consideration can be cash without triggering Revlon.” Indeed, the Court contrasted In re Santa Fe Pacific Corp. Shareholder Litigation (merger transaction involving consideration of 33% cash and 67% stock did not trigger Revlon) with In re Lukens Inc. Shareholders Litigation, (merger transaction involving consideration of 60% cash and 40% stock likely triggered Revlon).

The mixed cash/stock deal (44% cash and 56% CME stock) before the Court in NYMEX provided an opportunity for the Court to further narrow the 33%-60% range noted above and give guidance as to when Revlon would be triggered.

However, the Court decided that it did not need to address the threshold Revlon applicability issue because NYMEX’s Certificate of Incorporation contained an exculpatory clause authorized by 8 Del. C. § 102(b)(7) that protects the NYMEX directors from personal monetary liability for breaches of the duty of care. If the Plaintiffs failed to show that the either a majority of the directors were interested, lacked independence or failed to act in good faith, then their only remaining claim would be a breach of a duty of care which is addressed by §102(b)(7). Thus, even if Revlon applied, application of the §102(b)(7) exculpatory clause would lead to dismissal “unless the Plaintiffs have successfully pleaded a failure to act loyally (or in good faith), which would preclude reliance on the Section 102(b)(7) provision.”

Post-Lyondell Duty of Loyalty Discussed

As to the breach of the fiduciary duty of loyalty, the Plaintiffs alleged that the disinterested members of the Board were dominated and controlled by Schaeffer, and acted in bad faith. However, the Court held:

[t]hat directors acquiesce in, or endorse actions by, a chairman of the board—actions that from an outsider’s perspective might seem questionable—does not, without more, support an inference of domination by the chairman or the absence of directorial will. The NYMEX directors were otherwise unquestionably independent—this is not an instance where certain relationships raised some concern but not sufficient doubt to sustain a challenge to director independence. In short, the Complaint alleges nothing more than a board which relied upon, and sometimes deferred to, its chairman. It does not allege dominance such that the independence or good faith of the board may fairly be questioned.

Consequently, the claim for breach of the duty of loyalty failed as a matter of law and was dismissed.

“Because the Plaintiffs’ allegations were too conclusory to support an inference of domination,” the Court noted that for the Plaintiffs to succeed, they had to “convert into a loyalty claim their aversion to the process the Board employed in negotiating the merger” and the most the Plaintiffs could show was that “the Board’s process was not perfect.” Relying on the Delaware Supreme Court’s 2009 decision in Lyondell Chemical Co. v. Ryan, 970 A. 2d 2235 (Del. 2009) and the Court of Chancery’s decision in Wayne County Employees’ Retirement Systems. v. Corti, 2009 WL 2219260 (Del Ch. June 24, 2009), the Court explained :

The Delaware Courts have repeatedly held that “there is no single blueprint that a board must follow to fulfill its duties.” In any event, claims of flawed process are properly brought as duty of care, not loyalty, claims and, as discussed, those claims are barred by the exculpatory clause of NYMEX’s Certificate of Incorporation. Moreover, to the extent the Complaint alleges that the Board acted in bad faith, such allegations must fail because, based on the facts in the Complaint, it cannot be said that the Board intentionally failed to act in the face of a known duty to act, demonstrating a conscious disregard for its duties. More precisely, the Complaint has not alleged that the Board “utterly failed to obtain the best sale price.”

As a result, the Court granted the motion to dismiss the Complaint as to the breach of fiduciary duty claims.

Court Rejects Breach of Fiduciary Duty Claims Against Schaeffer
and Newsome as Sole Negotiators

Plaintiffs alleged that Schaeffer and Newsom breached fiduciary duties by “active participation in wrongdoing” in serving as the principal negotiators, specifically by:

[r]ejecting and keeping secret CME’s secret collar offer, ignoring the SIC, and withholding information regarding strategic opportunities and bids from fellow directors, as well as in ‘committing’ to CME that NYMEX would not attempt to renegotiate any of the economic terms of the proposed sale and failing to advise the Board of such a commitment, and in entering into an agreement with CME to vote their shares in favor of the proposed acquisition.

Moreover, Schaeffer was alleged to have breached his fiduciary duties by “rejecting NYSE’s interest in the Company due to NYSE’s failure to abide by his personal demands.” The Court dismissed these claims by holding that “[i]t is well within the business judgment of the Board to determine how merger negotiations will be conducted, and to delegate the task of negotiating to the Chairman and the Chief Executive Officer.” In addition, because the Board was “clearly independent,” there was no need for the utilization of the SIC.

Court Rejects Breach of Fiduciary Duty Claim Against Schaeffer and Newsome For Failure to Obtain a Collar

Characterizing Plaintiffs’ claim that Schaeffer and Newsome violated fiduciary duties by rejecting CME’s offer of a collar as speculative and conclusory, the Court held that

[t]he mere failure to secure deal protections that, in hindsight, would have been beneficial to shareholders does not amount to a breach of the duty of care. The presumption of deference to the judgment of management is only superseded by a showing of gross negligence, bad faith or conflicting personal interest. Plaintiffs have failed to plead the facts necessary to overcome this presumption.

The decision to omit a collar while negotiating merger terms was within the Board’s judgment. A post-facto analysis of the merits of a collar “is of no legal moment.” Accordingly, this claim was dismissed.

Direct v. Derivative Claims and the Parnes Exception

Returning to the NYSE offer, Plaintiffs alleged that Schaeffer stymied the potential bid (which Plaintiffs assert would have been greater than the ultimate deal with CME) by seeking a post-merger position for himself in the combined entity. The Court reasoned that these claims are not protected by the § 102(b)(7) clause because they pertain to breaches of a duty of loyalty. However, because claims pertain to a proposed NYSE acquisition and an entrenchment claim against Schaeffer, the claim was derivative. Following the merger, Plaintiffs’ standing to bring derivative claims was lost.

The general rule for determining “direct v. derivative” claims is set out in Tooley v. Donaldson, Lufkin & Jenrette, Inc., 845 A.2d 1031 (Del. 2004) as a two-part test: “(1) who suffered the alleged harm (the corporation or the suing stockholders, individually); and (2) who would receive the benefit of any recovery or other remedy (the corporation or the stockholders, individually).” The Court noted a very narrow exception to the general rule in Parnes v. Bally Entertainment Corp., 722 A.2d 1243 (Del. 1999). There, the Court held that “in order to state a direct claim with respect to a merger, a stockholder must challenge the validity of the merger itself, usually by charging the directors with breaches of fiduciary duty resulting in unfair dealing and/or unfair price.” A direct claim in such circumstances can be found only “[i]f the side transactions are alleged to have reduced the consideration offered to the target stockholders to a level that is unfair, then an attack is labeled as individual because it goes directly to the fairness of the merger.”

Here, the Court found that the “Plaintiffs’ allegations regarding the NYSE negotiations fell well outside the Parnes exception because the alleged breaches of fiduciary duty were far too attenuated from the ultimate CME transaction and the price that CME paid to establish a causal link.” As a result, the claim against Schaeffer was derivative and thus subject to dismissal. Moreover, because the confidentiality agreement with CME did not begin until months after NYSE’s interest waned, the Court noted that “it cannot be said that the failed negotiations with NYSE are in any way causally linked with the consideration ultimately offered in the CME transaction. . . . [and] there is no suggestion that the alleged breach occurred in order to benefit CME.”

Disclosure Claims

Plaintiffs claimed that the Board breached disclosure duties by failing to disclose:

• “more details concerning the NYSE’s then-potential offer of $142 per share;”

• “Schaeffer’s alleged self-interest in connection with an NYSE/NYMEX business combination;”

• “the fact that Schaeffer had been negotiating the terms of the transaction with CME;” and

• “additional information regarding the underlying assumptions of the fairness opinions, including an explanation for why J.P. Morgan and Merrill Lynch both used two transactions in their precedent transaction analysis that were never consummated.”

Plaintiffs also alleged that the bankers’ fairness opinions should have been updated in light of the reduced merger consideration relative to the time the opinions were initially made.

The Court started its analysis by noting that “the fiduciary duty of disclosure is a specific application of the duties of care and loyalty; it ‘requires that a board of directors ‘disclose fully and fairly all material information within the board’s control when it seeks shareholder action.’’” The Court then dismissed Plaintiffs’ disclosure claims for two reasons. First, to the extent the allegations were tied to the directors’ duty of care, they were barred because of the § 102(b)(7) charter provision. Second, to the extent they were tied to the duty of loyalty, they were dismissed because “[a] mere conclusory allegation that the alleged disclosure violations also constitute a violation of the duty of loyalty is not sufficient to survive a motion to dismiss, particularly in light of the holding that the Complaint fails to otherwise state a non-exculpated claim against the Director Defendants for breach of fiduciary duty.”

Dismissal of Aiding and Abetting Claims Against CME

Plaintiffs alleged that the CME Defendants aided and abetted the alleged breaches of fiduciary duty by the NYMEX Defendants. Because Plaintiffs were only able to muster conclusory allegations of the CME Defendants’ “knowing participation” in the alleged breach as non-fiduciaries, the Court found that their claims failed as a matter of law. The Court also noted that the complaint did not contain any allegation that the CME Defendants induced Schaeffer and Newsome to commit the alleged breaches.

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San Antonio Fire & Police Pension Fund v. Amylin  Pharmaceuticals, Inc., No. 4446-VCL (Del.Ch., May 12, 2009), read opinion here. This Chancery Court decision addressed the issue of "poison puts" or a provision in an indenture that would have triggered an obligation of the company, and a right of noteholders,  that allowed the holders of the notes to put their notes to the corporation at face value if a majority of the board changed control. This would have required Amylin to pay out $915 million in cash which was about $100 million more in cash than Amylin had available. The genesis of the case was an attempt by dissident shareholders to put a new majority of directors on the board.

[N.B.: On May 13, a Notice of Appeal was filed.]

Holding

The court rejected the arguments of the indenture trustee and held that: "... construed in accordance with generally applied standards, the provision is properly understood to permit the incumbent directors to approve as a continuing director any person, whether nominated by the board or a stockholder, as long as the directors take such action in conformity with the implied covenant of good faith and fair dealing and in accordance with their normal fiduciary duties."

 I will only focus on that part of the opinion that dealt with the application of Delaware law by the court on the fiduciary duty of care in light of New York law being applied to the interpretation of the indenture document.  However, for a discussion of the background facts and a general discussion of the case, see Prof. Gordon Smith's summary here which includes his closing tribute to the opinion's author, Vice Chancellor Lamb, whose terms expires soon (and he is not seeking reappointment).

A prior post here linked to an extensive background discussion of the case by Prof. Davidoff  soon after it was filed.

Expedited Proceedings. Trial Less Than Six Weeks from Original Complaint and Less than One Month From Fourth Amended Complaint

A quintessentially Delaware aspect of this case is the procedural celerity with which the case was decided, measured from the date the case was filed and put at issue. The purported class action complaint was filed on March 24, 2009. In early April a second and third amended complaint were filed. On April 16, a fourth amended complaint was filed. A pretrial conference was held on May 1 and a one-day trial was held on May 4 at which argument was also presented on cross-motions for summary judgment.  On May 6, two days after the close of the record, the indenture trustee asked the court to decline to rule, based on new facts, arguing that the issues are no longer ripe. On May 12, the Chancery Court issued its 28-page decision.

Key Points in Ruling on Fiduciary Duty of Care

 The issue decided by the court on this topic was whether the board or its delegate committee, breach the duty of care (i.e., was grossly negligent) in failing to learn of the existence of a provision in the indenture which triggered a right of noteholders to call the note if a majority of the board changed control?

The court ruled that "The answer must be no." In addition to explaining its ruling, the court provided instruction and advice to lawyers advising boards in similar situations.

(1) Reasoning for Ruling on Why Duty of Care Not Breached

 The court explained its rejection of the claim that board breached its fiduciary duty of care by not being aware of the provision that called for a default if the same directors did not continue in office, while noting that the directors relied on experienced counsel and that they should not be expected to read every word of a 98-page indenture. The actual language of the opinion is quoted below:

The board retained highly-qualified counsel. It sought advice from Amylin’s management and investment bankers as to the terms of the agreement. It asked its counsel if there was anything “unusual or not customary” in the terms of the Notes, and it was told there was not. Only then did the board approve the issuance of the Notes under the Indenture. This is not the sort of conduct generally imagined when considering the concept of gross negligence, typically defined as a substantial deviation from the standard of care.

The plaintiff argues that the board’s questioning if there was anything “unusual or not customary” in the Indenture was insufficient. But the way in which the board inquired into the material terms of the Indenture cannot be equated with gross negligence in failing to inform itself.45  Certainly, no one suggests that the directors’ duty of care required them to review, discuss, and comprehend every word of the 98-page Indenture.

(2) Instruction to Counsel Advising Boards regarding Long, Complex Documents that May Impinge on Shareholder Franchise

This decision provides somewhat practical instruction to both boards and the lawyers advising boards to be especially careful when approving terms in agreements that could interfere with what in Delaware is sacrosanct: the shareholder franchise (e.g., the right of shareholders to vote for and select directors) -- regardless of whether or not such language is deemed "customary" (which can mean different things to different parties), The actual excerpt from the opinion on this point follows:

This case does highlight the troubling reality that corporations and their counsel routinely negotiate contract terms that may, in some circumstances, impinge on the free exercise of the stockholder franchise. In the context of the negotiation of a debt instrument, this is particularly troubling, for two reasons.

 First, as a matter of course, there are few events which have the potential to be more catastrophic for a corporation than the triggering of an event of default under one of its debt agreements. Second, the board, when negotiating with rights that belong first and foremost to the stockholders (i.e., the stockholder franchise), must be especially solicitous to its duties both to the corporation and to its stockholders. This is never more true than when negotiating with debtholders, whose interests at times may be directly adverse to those of the stockholders. Outside counsel advising a board in such circumstances should be especially mindful of the board’s continuing duties to the stockholders to protect their interests. Specifically, terms which may affect the stockholders’ range of discretion in exercising the franchise should, even if considered customary, be highlighted to the board. In this way, the board will be able to exercise its fully informed business judgment.

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Lyondell Chemical Co. v. Ryan, Del. Supr. (March 25, 2009), read opinion here.  See revised opinion of  April 16, 2009 here. The Delaware Supreme Court rendered this unanimous en banc decision last evening. It was much anticipated in the corporate law world and in the few hours since its release it has already generated substantial commentary among corporate law professors and similar commentators.

Kevin Brady, a highly respected Delaware litigator, has provided us with the following review of the opinion:

In its decision on an interlocutory appeal, Delaware's High Court reversed the Court of Chancery’s July 29, 2008 decision denying summary judgment for the directors of Lyondell Chemical Company (“Lyondell”) as to the “Revlon” and “deal protection” claims and whether the directors of Lyondell acted in good faith in conducting the $13 billion sale of Lyondell.

The class action complaint alleged that the Lyondell directors breached their fiduciary duties of care, loyalty and candor and put their personal interests ahead of the interests of the Lyondell shareholders. In particular, the complaint alleged that: (i) the merger price was grossly insufficient; (ii) the directors were motivated by self-interest; (iii) the process by which the merger was negotiated was flawed; (iv) the directors agreed to unreasonable deal protection provisions and (v) the preliminary proxy statement omitted numerous material facts. By way of background, the merger price represented a substantial premium over the market price and the merger was approved not only by a disinterested board but also by more than 99% of the voted shares.

Lyondell’s charter contained an exculpatory provision pursuant to 8 Del. C. § 102(b)(7), protecting the directors from personal liability for breaches of the duty of care, so the case turned on whether there were any shortcomings on the part of the directors to implicate their duty of loyalty, a breach of which is not exculpated. Because the Court of Chancery had found that the board was independent and was not motivated by self-interest or ill will, the focus became whether the directors were entitled to summary judgment on the claim that they breached their duty of loyalty by failing to act in good faith.

Court of Chancery Focuses on Process and Deal Protection Provisions

The Court of Chancery rejected all of the plaintiffs’ claims except those directed at the process by which the directors sold the company and the deal protection provisions in the merger agreement. In particular, whether under Revlon v. MacAndrews & Forbes Holdings, Inc. (506 A. 2d 173, 182 (Del. 1986)), the directors failed to obtain the best available price in selling the company. The Court of Chancery decided that “unexplained inaction” by the Lyondell directors for two months permitted a reasonable inference that the directors may have consciously disregarded their fiduciary duties. The Supreme Court disagreed finding that there was no evidence from which to infer that the directors knowingly ignored their responsibilities, thereby breaching their duty of loyalty.

Justice Carolyn Berger writing for the Court examined the concepts of “bad faith” and “failure to act in good faith” as well as the range of conduct that might be classified as such in light of existing Delaware case law. See, In re Walt Disney Co. Deriv. Litig. (906 A. 2d 27 (Del. 2006)), Stone v. Ritter, (911 A. 2d 362 (Del. 2006) and In re Caremark Int’l Deriv. Litig. (698 A. 2d 959 (Del. Ch. 1996). While the Court of Chancery had denied summary judgment in order to obtain a more complete record before deciding whether the directors had acted in bad faith, the Supreme Court determined that the trial court “reviewed the existing record under a mistaken view of the applicable law.” The Supreme Court went on to note that there were three factors that contributed to that mistake: (i) the Court of Chancery imposed Revlon duties on the directors before they either decided to sell, or before the sale had become inevitable; (ii) the Court of Chancery read Revlon and its progeny as creating a set of requirements that must be satisfied during the sale process; and (iii) the Court of Chancery “equated an arguably imperfect attempt to carry out Revlon duties with a knowing disregard of one’s duties that constitutes bad faith.”

When Exactly Do Revlon Duties Arise?

In analyzing Revlon and its progeny, the Court of Chancery determined that the directors must actively engage in the sale process, and confirm that they have obtained the best available price either by conducting an auction, a market check or demonstrating “an impeccable knowledge of the market.” The Court of Chancery concluded that because the Revlon sale process must follow one of the these courses of conduct identified above and that the Lyondell directors had not followed any of the standards that the Court of Chancery extracted from Revlon and its progeny, the directors were unable to meet their burden under Revlon.

The Supreme Court disagreed noting that the problem with the Court of Chancery’s analysis was that Revlon duties arise not because a company is “in play” (such as in this case where there was a Schedule 13D filing) but rather when the company “embarks on a transaction – on its own initiative or in response to an unsolicited offer – that will result in a change of control.” In this case, that was when the Lyondell directors began negotiating the sale of Lyondell. The Supreme Court further noted that “there is no legally prescribed steps that directors must follow to satisfy their Revlon duties” and that the Lyondell directors failure to take any specific steps during the sale process could not have demonstrated a “conscious disregard of their duties.”

The Supreme Court concluded that the Court of Chancery “approached the record from the wrong perspective. Instead of questioning whether disinterested, independent directors did everything that they (arguably) should have done to obtain the best sale price, the inquiry should have been whether those directors utterly failed to attempt to obtain the best sale price.” Finding that the record clearly established that the Lyondell directors did not breach their duty of loyalty by failing to act in good faith, the Supreme Court reversed the decision of the Court of Chancery and remanded the matter for entry of judgment in favor of the Lyondell directors.

SUPPLEMENT: Professor Stephen Bainbridge provides a scholarly analysis here. Dean and Professor Eric Chiappinelli provides his learned overview of the case here. Professor Gordon Smith gives us the benefit of his professorial insights here. Attorney  Bernard Sharfman of the Cohen Milstein firm has written a thoughtful article that includes a discussion of this case here.

Some of the extensive commentary on the trial court's opinion is collected here.

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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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 County of York Employees Retirement Plan v. Merrill Lynch & Co., Inc., et al., (Del. Ch., Oct. 28, 2008), read opinion here. This 39-page Chancery Court decision addressed in a cursory but scholarly manner, several preliminary issues related to the recently announced merger of Merrill Lynch and Bank of America.

The opinion is a treasure trove of Delaware corporate law principles and practical corporate litigation tools that directly address the Delaware legal issues that have arisen in connection with the recent economic crisis of historic proportions. One indication of the seismic shifts we are witnessing is the comparatively large "two-inch high headlines" recently seen on the front page of The Wall Street Journal as formerly unthinkable "fire-sales" have been negotiated on more than one occasion "over a weekend" for blue chip companies that were formerly the 800-pound gorillas of industry (e.g., Merrill Lynch).

I am hoping that some of the corporate law professors  who have their own blogs will add their scholarly analysis to this case, but  for now I only have time to identify a few highlights. The court cursorily reviewed the following claims that were made about the transaction:

• self-interested directors (not a majority)
• duty of care
• deal protection claims
• irreparable harm (in connection with request for expedited proceedings)
• disclosure claims
• financial advisor compensation (and disclosure of same)
• chairman's compensation package (and disclosure of same)

 In this preliminary overview of certain issues, the court denied a motion to stay this Delaware case in favor of a related federal case in New York, and  Chancery also granted expedited proceedings in this case (and explained why it did so).

The court addressed the criteria that will be applied to decide when an amended complaint will relate back to the date of the original complaint for purposes of determining if it was the "first-filed" complaint compared to a similar suit in another forum. In Delaware, this is known as a "McWane analysis", after the Delaware Supreme Court decision of that name. In this regard, the court noted that if it is a "close call", such as when two suits are filed within a day or so of each other, they may be considered as filed contemporaneously. When that occurs, the court observed as follows:

Under the McWane analysis, a court, in the exercise of its discretion, may stay an action “when there is a prior action pending elsewhere, in a court capable of doing prompt and complete justice, involving the same parties and the same issues.” 5   If the foreign action is not “first-filed,” the Court will pursue an inquiry “akin to a forum non conveniens analysis.”  6

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