There are not many Chancery decisions on Rule 11 compared with more common issues that are the subject of Chancery decisions, and a recent letter decision provides insights into why there are not more rulings on that issue. In POSCO Energy Co., Ltd. v. FuelCell Energy, Inc., Civil Action No. 2020-0713-MTZ (Del. Ch. Oct. 22, 2020), the court explained that Rule 11 should not be casually raised, but that in any event a requirement for invoking it is to provide separate written notice and an opportunity to cure, as opposed to including it as part of a separate motion.

The Court explained that:

FuelCell has invoked Court of Chancery Rule 11 casually and repeatedly in this matter. 21 The Court may only determine if Rule 11(b) was violated “after notice and a reasonable opportunity to respond,” and a litigant may only initiate those proceedings by “[a] motion for sanctions . . . made separately from other motions or requests.” 22 Under that plain language, if FuelCell seeks sanctions for conduct it believes violates Rule 11, it must do so in an independent motion, not in argument opposing unconditional leave to amend. And, in my view, it is distracting, detrimental to the famed collegiality of the Delaware bar, and counterproductive to the “just, speedy and inexpensive determination” of judicial proceedings to summon Rule 11 in rhetoric. 23

 

22 Ct. Ch. R. 11(c); id. 11(c)(1)(A); see Crumplar v. Superior Ct. ex rel. New Castle Cnty., 56 A.3d 1000, 1005 (Del. 2012) (noting Superior Court Rule 11’s identical language “provides a trial judge with authority to impose an ‘appropriate sanction’ on attorneys who violate Rule 11(b), but only after notice and a reasonable opportunity to respond”). “[F]or this Court to address directly an alleged violation of the Rules, that violation must involve prejudice to the fairness of the proceeding itself. Furthermore, such a finding must be supported by clear and convincing evidence.” OptimisCorp. v. Waite, 2015 WL 5147038, at *6 (Del. Ch. Aug. 26, 2015) (citation and internal quotation marks omitted).

23 Ct. Ch. R. 1; see Coughlin v. S. Canaan Cellular Invs., LLC, 2012 WL 2903924, at *2 (Del. Ch. July 6, 2012) (“‘[L]awyers should think twice, three times, four times, perhaps more before seeking Rule 11 sanctions or moving for fees under the bad faith exception. These types of motions are inflammatory.’ An unwarranted motion for fee shifting under the bad faith exception can itself justify a finding of bad faith and fee shifting.” (quoting Katzman v. Comprehensive Care Corp., C.A. No. 5892–VCL, at 13 (Del. Ch. Dec. 28, 2010) (TRANSCRIPT)).

This post was prepared by Frank Reynolds, who has been following Delaware corporate law, and writing about it for various legal publications, for over 30 years.

The Court of Chancery recently barred a Scientific Games Corp. investor from suing ex-Chairman Ron Perelman and his “hand-picked” directors in Delaware because the plaintiff couldn’t prove it was tricked into approving a mandatory forum selection bylaw requiring all corporate governance charges to be tried in Nevada where officers and directors would allegedly be shielded, in Sylebra Capital Partners Master Fund Ltd. et al. v. Perelman, et al., No. 2019-0843-JRS opinion issued (Del. Ch. Oct. 9, 2020).

In his Oct. 9 opinion, Vice Chancellor Joseph Slights dismissed shareholder Sylebra Capital Partners’ breach of duty and declaratory judgment counts on venue grounds.  He  said although Perelman’s alleged scheme to force Sylebra to sell out at an unfairly low price began when SGC was a Delaware-chartered company and invokes Delaware General Corporation Law, Sylebra knew what might happen when the Nevada-based gaming company reincorporated in Nevada in early 2018 and revised its bylaws.

Moreover, the plaintiff had a year to make its charges as counterclaims in a first-filed suit by SGC against Sylebra in the Nevada state court designated in the mandatory forum bylaw — an action that related to the internal affairs claims Sylebra made instead in Delaware, the vice chancellor said.

Not like Delaware forum selection clauses

The suit stands out against the backdrop of the Delaware litigation that has stemmed from the First State’s recent enactment of Delaware General Corporation Law § 115, which allows Delaware corporations to specify through their charter or bylaws, that all litigation involving the company’s internal affairs must be brought exclusively in the Delaware courts.

Section 115 allowed companies to cope with the problem of multi-forum litigation over mergers or other disputed deals by forcing all plaintiffs to sue in one forum — Delaware.  But in this case, the SGC board specified the Nevada state court as the mandatory forum.

The wrong forum

The vice chancellor said Chancery is the wrong forum here because:

(1) plaintiffs seek to invalidate provisions of Delaware constitutive documents that no longer exist,

(2) plaintiffs were stockholders at the time Scientific Games left Delaware for Nevada, yet at no time before now have they challenged that move or sought to pursue their supposed Delaware claims;

(3) plaintiffs’ claims require the Court to decide whether provisions in the constitutive documents of a Nevada corporation are enforceable;

(4) the company’s mandatory Nevada forum selection bylaw is broad and unambiguously covers plaintiffs’ supposed Delaware claims; and

(5) there is a first-filed action pending in Nevada before a court that is fully capable of adjudicating all claims between these parties.

The alleged Perelman scheme

Sylebra charges that Ronald Perelman, who owned 39 percent of SGC through his holding company, McAndrews & Forbes, wanted to force Sylebra out and used the tight gaming industry regulations that governed SGC and its subsidiary, Bally Gaming, Inc., to subject Sylebra to a series of trumped-up investigations into its “suitability” as a gaming investor.

Meanwhile, Perelman misused his influence over the SGC directors  to force through by-law changes that allowed the company to freeze and then forcibly redeem investments by any shareholder found “unsuitable” due to the taint of suspicion that such investigations might incur, the suit says.

At the same time, Perelman tricked the shareholders into supporting a 2018 charter change to Nevada on the pretext that SGC would then be less vulnerable to suits by activist investors hoping to force short-term profit changes on the board, Sylebra claims.  But in fact, the move was made to insulate the directors and officers from liability for helping Perelman elbow Sylebra out and gain power the suit says.

Wrong venue

Addressing defendants’ motion to dismiss under both Chancery Rule 12(b)(3) for improper venue and Chancery Rule 12(b)(6) for failure to state viable claims , Vice Chancellor Slights first denied Sylebra’s belated motion to amend the claims, finding that plaintiff in effect, put the cart before the horse by concentrating on opposing dismissal under 12(b)(6) before seeking leave to amend.

He then found that:

Any request to have the Chancery Court declare SGC’s Delaware charter or bylaw provisions invalid “faces an immediate and insoluble problem”—they ceased to exist after reincorporation.

Any request to have Chancery invalidate the Nevada charter or bylaw provisions would have this Court do “what this Court strongly prefers courts in other jurisdictions not do with respect to Delaware corporations—decide matters that impact the internal affairs of a corporation chartered in another state.”

It is indisputable that the Nevada Charter and Nevada Bylaw provisions implicated by Sylebra’s claims fall within the purview of the internal affairs doctrine.

No escape from forum clause

The vice chancellor ruled that contrary to Sylebra’s assertions:

It did consent to the forum selection bylaw because it knew SGC required securities in the company to “be held subject to the suitability standards” so it might be barred from selling its stock and  besides “the link Sylebra attempts to draw between the ability of a stockholder to sell its shares and that stockholder’s consent to the corporation’s bylaws finds no support in our law.”

The forum selection bylaw Is not unreasonable or unjust because plaintiff’s allegation that Nevada state courts are accustomed to “only holding fiduciaries accountable for ‘intentional misconduct, fraud or a knowing violation of the law” is an unsupported characterization of the Nevada courts.

The forum bylaw was  not procured by fraud because Sylebra failed to allege: “the time, place, and contents of the false representation, the identity of the person(s) making the representation, and what he intended to obtain thereby.”  Plaintiff never opposed the adoption of the bylaw when it was clearly presented for adoption and never provided specifics to support its claim that Nevada law would insulate the directors from fiduciary duty charges.

 

 

 

 

 

 

 

 

A recent letter ruling from the Court of Chancery clarified the procedural distinction between a statutory proceeding considered “summary” in nature, and a case that may involve exigent circumstances for which a Motion to Expedite may be warranted. In PL Wardman Member, LLC v. JBGS/Company Manager, L.L.C., No. 2020-0754-JRS (Del. Ch. Sept. 21, 2020), the Court reviewed a Motion to Expedite in a dissolution case.

The Court explained that: “Summary means expedited, at least relative to plenary actions.” And the decision added that when “addressing scheduling with respect to statutory summary proceedings, this court does not dwell on the traditional standards applied to other motions to expedite… [and] we move summary proceedings along….”

This decision is a useful tool for the toolbox of litigators who toil in the fields of the Court of Chancery.

This post was prepared by Frank Reynolds, who has been following Delaware corporate law, and writing about it for various legal publications, for over 30 years.

A discovery ruling by the Delaware Court of Chancery in a contest between two board factions for control of Adkins Energy LLC allowed plaintiff Pearl City Elevator, Inc. access to the attorney-client-privileged documents of a rival faction only in areas where Pearl’s interests were not adverse to those of Adkins’ in Pearl City Elevator, Inc. v.  Gieseke, et al. C.A. No. 2020-0419-JRS letter opinion (Del. Ch. Sept. 21, 2020). The Court also addressed standing issues in a manner that contrasts with the conclusion by the same jurist in an earlier, unrelated case.

Vice Chancellor Joseph Slights’ Sept. 21 ruling was a split decision on investor Pearl City’s motion to compel production of documents generated by the law firm hired to advise Adkins three general board members who opposed a claim by Pearl’s three board members that they now owned enough Adkins stock to appoint a tie-breaking seventh representative.

As a limited liability company, Adkins could sell ownership interests to limit risk like a corporation, but could set its corporate governance rights and responsibilities by contract rather than by Delaware state law; and one of those rights allowed Pearl to appoint a seventh board representative after it acquired 56 % of Adkins.

Background

When the Adkins board members questioned the validity of the share purchases and got advice from a law firm separate from the rest of the boar. Pearl subpoenaed the relative documents, claiming their rivals could not shut them out simply because they had disagreements according to the court.

Basic Principles

Like the directors of corporations, LLC managers normally have unfettered access to even attorney-client-privileged or work product privileged information, but there are three exceptions:

(1) A board member can limit his or her rights by agreement ex ante.

(2) A board can form a special committee excluding the director, and that committee can engage legal counsel, and then that committee’s communications would be protected.

(3) Privileged information can be withheld “once sufficient adversity exists” between the board member and the entity, such that the board member “could no longer have a reasonable expectation that he was a client” of counsel to the entity.

The vice chancellor set out three “baskets” of information in this action’s discovery disputes:

(1) documents relating to the firm’s retention and billings;

(2) documents relating to the parties’ performance in a Grain Delivery Contract between Pearl and Adkins that helped Pearl acquire the 56% stock ownership mark and

(3) documents relating to the validity of Pearl’s attempt to place a seventh board representative

Get what you need?

He noted that the current motion is in an expedited proceeding in a summary action, so “the court’s orientation regarding the scope of discovery, typically follows the guidance of two ageless philosophers:”  “You can’t always get what you want, but if you try sometimes, you just might find, you get what you need.”   Richards, Jagger, You Can’t Always Get What You Want © Abko Music, Inc. (1969).

In this case, regarding item one, that means that retention agreements and law firm Locke Lord LLC’s bills may fit into the “can’t always get” category but Pearl must receive the core issue documents, which fall into the “get what you need” category, the court ruled in denying the motion for those documents and and granting the motion regarding the core issue-related records, he said.

As to item two, he found Pearl clearly waived access to much of the information regarding the GDA pack and has admitted its adverse position regarding the contract, so that part of the motion is denied.

Pearl has standing

Regarding Pearl’s demand on item three for legal documents generated in the Adkins opposition to Pearl’s bid for a seventh board member, the court rejected Adkins’ arguments that Pearl City, as a member, is the only plaintiff in this litigation and it cannot assert a right to Adkins’ privileged information.  The vice chancellor denied that part of the motion, finding that on the question of the seventh board member, Pearl City has standing and is just as much the ‘client’ of Locke Lord as Adkins and the general board members are.

He agreed with Pearl City that a Chancery Court decision in Moore Business Forms, Inc. v. Cordant Holdings Corporation directly refutes Locke Lord’s argument that Pearl has no standing in that matter.  Moore Business Forms, Inc. v. Cordant Holdings Corporation 1996 WL 307444 (Del. Ch. June 4, 1996).

“Nothing in the LLC’s operating agreement would restrict the Pearl City’s board members’ right to access privileged information from Adkins’ counsel; there are no Related Transactions involved in Pearl City’s attempts to acquire additional Adkins units or in its effort to assert control over the Board,” the court said.

Adversity

That leaves adversity as the only basis on which Locke Lord can prevent Pearl City from accessing the privileged information Pearl City seeks with respect to the control dispute, the vice chancellor said.   He disagreed with Locke Lord’s argument that this case is different from the typical control dispute because Pearl City’s unit acquisitions threaten Adkins’ qualification to continue to be taxed as a partnership for federal income tax purposes, thereby rendering Pearl City and Adkins adverse.

First, he said, “Locke Lord has not demonstrated, as is its burden as the proponent of the privilege, that Pearl City has a desire to impair Adkins’ federal tax status or otherwise adversely affect the company” and if the law firm has formed an expert opinion that Pearl City is endangering Adkins’ tax status, it should be sharing that advice with all members of the board.

Conclusion

The court said Locke Lord need not produce information on retention and billings or advice given regarding the GDA pact, but it must produce:

(1) all communications and documents concerning the appointment of the seventh board member and private sales of Adkins units between Pearl City and certain general members; and

(2) communications with the general board members concerning the topics identified above as “core issues in dispute.”

Practitioner’s postscript

Practitioners who deal with this area of law know the outcome of such disputes are often very fact dependent – especially on matters of standing – and they will probably want to compare this ruling with the very different decision by the same jurist in a recently decided Chancery matter in Solar Reserve CSP Hldgs., LLC v. Tonopah Solar Energy, LLC, C.A. No. 2020-0064-JRS opinion issued (Del. Ch. July 24, 2020).

In his Sept. 21 Pearl City ruling, Vice Chancellor Slights said Pearl City had standing and the only question was whether it gave up its right to discovery through waiver or adversity.

In the Solar ruling, in which documents were sought based on a provision in an LLC Agreement, the same jurist found plaintiff Solar Reserve lacked standing from the start because it assigned all claims it had against defendant Tonopah to–what the Court held was–an unaffiliated third party. Under that agreement, that meant Solar Reserve was not the real party in interest and could not maintain that action under Court of Chancery Rule 17(a), because in the Court’s view the assignee had no information rights under the LLC agreement. The Solar ruling was about to be appealed when Tonopah filed for bankruptcy.

 

 

 

 

There remains a relative paucity of opinions addressing the nuances of the dissolution statute under DGCL Section 280, compared to the Delaware decisions addressing other sections of the DGCL, so we refer to a recent Court of Chancery decision that denies a Motion for Reargument under Rule 59(f) of a ruling that rejected a request to set aside a reserve for a fraud claim–even though the letter ruling was barely three-pages long–in the matter styled In re Swisher Hygiene, Inc., 2018-0080-SG (Del. Ch. Sept. 4, 2020).

The Court explained that the allegations did not state a “creditor claim”, though the ruling expressly did not prejudice the right to “bring litigation to determine” the fraud claim, which related to disputed ownership of stock in the company being dissolved.

The original Chancery opinion was highlighted on these pages.

A recent Delaware Court of Chancery decision addressed the issue of whether a seller was liable for not disclosing the notification it received prior to closing that one or more key customers were terminating their relationship with the seller’s business. Swipe Acquisition Corporation v. Krauss, C.A. No. 2019-0509-PAF (Del. Ch. Aug. 25, 2020). This decision and others cited below must be read by anyone who seeks a deep understanding of Delaware law on this topic.

Key Issue Addressed:

When will a fraud claim survive in connection with a purchase agreement that restricts claims for misrepresentations and limits claims for indemnification? In this case, most of the motion to dismiss was denied, but one of the reasons this decision is noteworthy is because it exposes the lack of a bright-line-rule on this issue when compared to other decisions addressing the same or similar issues–depending on the specific terms of the anti-reliance clause involved and the specific claims of fraudulent misrepresentations or omissions.

Many cases addressing this issue have been highlighted on these pages over the last 15 years. E.g., the Prairie Capital case in which yours truly was one of the counsel involved, and the ChyronHego Corp. decision.

As an indication of how common this issue is, a few days ago the Court of Chancery issued another decision that addressed the titular issue: Pilot Air Freight, LLC v. Manna Freight Systems, Inc., No. 2019-0992-VCS (Del. Ch. Sept. 18, 2020).

But we are fortunate to have a compilation of cases by the highly valuable electronic publication called The Chancery Daily (subscription required) that has compiled cases that have addressed the titular issue and which–though factually determinative to the extent the cases are tethered to their facts–manifest what some readers might describe as a lack of unanimity or at least the lack of a bright-line-test. This topic could easily be the subject of a law review article, but for present purposes, with thanks to The Chancery Daily, in its editions dated September 14, 15, and 17, 2020, the following cases should be consulted for anyone interested in a comprehensive understanding of Delaware law on this topic:

ABRY Partners V, LP, et al. v. F&W Acquisition, LLC, et al., C.A. No. 1756-VCS, opinion (Del. Ch. Feb. 14, 2006)

Anvil Holding Corp., et al. v. Iron Acquisition Co., Inc., et al., C.A. No. 7975-VCP, memo. op. (Del. Ch. May 17, 2013)

TEK Stainless Piping Products, Inc. v. Sheila Mahony Smith, et al., C.A. No. N13C-03-175-MMJ-CCLD, memo. op. (Del. Super. Oct. 14, 2013)

Universal American Corp. v. Partners Healthcare Solutions Holdings, LP, et al., C.A. No. 13-1741-RGA, memo. op. (D. Del. July 24, 2014)

ITW Global Investments, Inc. v. American Industrial Partners Capital Fund IV, LP, et al., C.A. No. N14C-10-236-JRJ-CCLD, opinion (Del. Super. June 24, 2015)

FdG Logistics, LLC v. A&R Logistics Holdings, Inc., C.A. No. 9706-CB, opinion (Del. Ch. Feb. 23, 2016);

Universal American Corp. v. Partners Healthcare Solutions Holdings, LP, et al., C.A. No. 13-1741-RGA, memo. op. (D. Del. Mar. 31, 2016)

IAC Search, LLC v. Conversant, LLC, C.A. No. 11774-CB, memo. op. (Del. Ch. Nov. 30, 2016)

Stephen B. Trusa v. Norman Nepo, et al. and XION Management, LLC, C.A. No. 12071-VCMR, memo. op. (Del. Ch. Apr. 13, 2017)

ChyronHego Corp., et al. v. Cliff Wight, et al., C.A. No. 2017-0548-SG, memo. op. (Del. Ch. July 31, 2018)

Affy Tapple, LLC v. ShopVisible, LLC, et al., C.A. No. N18C-07-216-MMJ-CCLD, opinion (Del. Super. Mar. 7, 2019)

Joseph C. Bamford, et al. v. Penfold, LP, et al., C.A. No. 2019-0005-JTL, memo. op. (Del. Ch. Feb. 28, 2020)

Wind Point Partners VII-A, LP v. Insight Equity AP X Co., LLC, et al., C.A. No. N19C-08-260-EMD-CCLD, opinion (Del. Super. Aug. 17, 2020)

Some of the foregoing cases have been highlighted on these pages. This may not be a complete list of Delaware cases that cover the fraud v. anti-reliance clause issue, but it’s a great start.

Key Facts of Swipe case:

This case involves a dispute over the lack of disclosure by the seller prior to closing when the seller learned that a key customer was claiming to terminate its business relationship even though the sales price was impacted by the existence of key customers. The sellers knew that if the buyers learned of the termination by the key customer involved that the deal might not close. See Slip op. at 8. Nonetheless, the sellers did not inform the buyers of the termination of the key customer at issue. Moreover, the sellers did not amend any of the financial information provided to the buyers, which had then become stale. Id. at 9. Based on weaker-than-expected performance before the closing, the buyers and the sellers did agree to reduce the purchase price even though the loss of the key customer was not disclosed.

Key Principles of Law with Widespread Applicability:

  • The court cited to multiple cases to explain when an anti-reliance clause will not bar a fraud claim. See Slip op. at 28-29.
  • The court also elucidates when a fraud claim and a contract claim will not be considered duplicative; when both can proceed at the preliminary stage of a case; and when a contract claim and a fraud claim will not be considered boot-strapped. See id. at 31-33.
  • The court explained why duplicative claims may often survive at the motion to dismiss stage. See footnote 61 and accompanying text.
  • The court explained the primacy of contract law in Delaware, and when parallel contract claims and breach of fiduciary duty claims may not proceed in tandem. See footnote 58 and accompanying text.

In addition to the cases cited above on the topic at hand, this decision should be compared with the Delaware Superior Court’s Infomedia decision that was issued just a few short weeks before this Chancery ruling. Of course, the exact terms of the applicable agreements and the detailed circumstances are often determinative, but in the unrelated Delaware Superior Court decision about a month earlier, the court concluded that the failure to inform the sellers shortly before the execution of an asset purchase agreement that key customers intended to terminate their service contracts, even though written notice had not yet been received, would not be a sufficient basis for fraudulent misrepresentation claims due to anti-reliance provisions in an asset purchase agreement, thereby resulting in a grant of the motion to dismiss, based on the terms of the agreement involved in that case. See Infomedia Group Inc. v. Orange Health Solutions, Inc. (Del. Super. July 31, 2020).

 

This post was prepared by Frank Reynolds, who has been following Delaware corporate law, and writing about it for various legal publications, for over 30 years.

In a recent ruling dismissing shareholder charges that Outerwall Inc.’s directors disloyally sold the automated vendor company too cheaply to avoid losing their seats in a looming proxy fight with an activist investor, the Delaware Chancery Court found the plaintiff fell short of showing that the board lacked independence and objectivity in Rudd v. Brown, et al., No. 2019-0775-MTZ opinion issued (Del. Ch. Sept. 11, 2020.)

Vice Chancellor Morgan Zurn’s September 11 opinion found although Outerwall’s directors’ allegedly self-interested failure to get the best price for the shareholders was subject to heightened scrutiny under the seminal Revlon ruling, that was insufficient to survive a dismissal motion because the board was protected by an exculpatory clause – which shields directors from money claims for duty-of-care breaches.

Under Revlon, the court must examine whether the directors of the corporation have performed their fiduciary duties “in the service of a specific objective: maximizing the sale price of the enterprise” in a change-of-control situation. Revlon, Inc. v. MacAndrews & Forbes Holdings, Inc. 506 A.2d 173, 183 (Del. 1986).

More than Revlon

But even if the directors’ merger decision was defective and shortchanged the Outerwall investors, that, without more, would not constitute the breach of duty of loyalty charge that was needed to overcome an exculpatory clause adopted under 8 Del. C. §102(b)(7), the court said.

To state that type of claim, class action plaintiff Mark Rudd would have had to show that in addition to the merger price charge, each of the defendant directors had a disabling lack of independence or objectivity or exhibited bad faith, but he failed to do that, the vice chancellor said.

Background

After the directors agreed to a two-step merger in which Rudd was forced to sell his shares when the first step was completed, Rudd filed suit in 2019 claiming that after Redbox video rentals, Outerwall’s core business, slumped, the directors caved in to pressure from activist investor Engaged Capital, LLC to sell.

Rudd claimed that instead of taking reasonable steps to increase Outerwall’s value, the directors and CFO Galen Smith panicked when Engaged set a deadline for action on a sale and self-interestedly agreed to a transaction that undervalued the company and misled investors about the deal and how it was negotiated.

Too much like Lukens

But Vice Chancellor Zurn said, Delaware courts “have expressed reluctance to find” that directors are conflicted “simply because they operate under the threat of a proxy contest.” She pointed to In re Lukens Inc. Shareholders Litigation 757 A.2d at 729 where the court rejected the plaintiffs’ assertion that the directors who approved the relevant merger were improperly motivated because of “the possibility of a proxy contest at the . . . annual stockholder meeting.”

Her Honor noted that in the three cases the plaintiff cited, where the court “found conflict in board decisions made in the shadow of a proxy contest,” it was “only where those decisions bore other indicia of gross negligence or disloyalty. Plaintiff’s allegations offer no such meat on the bone.”

“It is clear that a director’s independence is not compromised by virtue of his status as a stockholder appointee …Nor was it enough to allege that another was conflicted by virtue of the benefits he received from the acquisition,” the court said, adding that plaintiff’s theory that CFO Smith was conflicted by his pursuit of post-close employment is also insufficient to state a breach of duty claim.

The allegations in the amended complaint “boil down instead to the barebones conflict theory rejected in Lukens.” the vice chancellor concluded in dismissing all charges against the directors and the CFO.

 

This past week I was the subject of an online video interview that was livestreamed on Facebook. LexBlog, the company that provides the “backroom” software support to host this blog, conducted the interview and we talked about the genesis of this blog and why I have continued to publish this blog over the last 15 plus years. For any lawyers, or others, interested in blogging in general, the interview may provide useful information.

This post was prepared by Frank Reynolds, who has been following Delaware corporate law, and writing about it for various legal publications, for over 30 years.

The Delaware Court of Chancery recently decided AmerisourceBergen Corporation shareholders’ breach-of-duty suit was one of the few Caremark claims to pass Delaware’s pre-suit demand test because it may prove the directors and officers turned a blind eye to a subsidiary’s criminal enterprise of cancer drug repackaging in Teamsters Local 443 Health Services & Insurance Plan et al. v. Chou, et al., No. 2019-0816-SG memorandum opinion issued (Del. Ch. Aug. 24, 2020).

Vice Chancellor Sam Glasscock’s Aug. 24 memorandum opinion refused to dismiss charges by employee pension fund plaintiffs that sufficiently alleged ABC’s directors likely faced bad faith liability and therefore lacked the independence and objectivity necessary to decide, as the company’s managers, whether the derivative suit should live or die.

In an opinion that will be studied in law offices and boardrooms nationwide, the vice chancellor acknowledged the widely-held belief of Delaware jurists and litigators that Caremark duty-to-supervise charges are the most difficult to get past the threshold test for claims brought against officers and directors on behalf of the company.

What the directors didn’t do

He said that’s because Caremark suits center not on what the defendant officers and directors purportedly did but what they allegedly didn’t do – and whether there is proof that shareholders suffered because directors and officers intentionally “utterly failed” to establish or check monitoring systems for the company’s “mission critical” operations that hinged on regulatory compliance.

Chancellor William Allen’s 1996 In re Caremark International ruling set tough standards for shareholder plaintiffs to recover on behalf the corporation itself in the rare case where, “directors, otherwise unconflicted, should nonetheless take actions knowingly inimical to the corporate interest, such as ignoring a known duty to act to prevent the corporation from violating positive law.” Vice Chancellor Glasscock said. In re Caremark Int’l Inc. Derivative Litig., 698 A.2d 959 (Del. Ch. 1996).

Background

According to the 2019 complaint, that is exactly what happened in 2001 when AmerisourceBergen Corp., a Delaware-chartered pharmaceutical distribution and sourcing company based in Chesterbrook, Pa., acquired Oncology Supply Pharmacy Services and made it part of AmerisourceBergen Specialty Group.

The consolidated complaint of a half-dozen union pension plans says that company’s sole official business was to buy single-dose sterile vials of oncology drugs, put those drugs into syringes, and sell the syringes for injection into a cancer patient’s body; but instead, OSPS emptied the syringes—including the excess in each used to eject air bubbles — into a pool of medicine that produced enough for extra syringes with full dosages.

The complaint alleged that Pharmacy not only illegally “pooled” and sold the overfill as extra syringe doses, its unsterile process produced medicine contaminated with “floaters,” in more than 32,000 pre-filled syringes between 2007 and 2013 alone. Pharmacy and ABC both pocketed the extra revenue, and undercut the competition by providing kickbacks to buyers to increase market share, the complaint said. In addition, Pharmacy was not really a pharmacy, but it generated fake prescriptions to masquerade as a pharmacy business in order to avoid scrutiny by the U.S. Food and Drug Administration as a drug manufacturer.

ABC’s directors and top officers – including Steven H. Collis, ABC’s Chairman, President, and Chief Executive Officer, who was President of Pharmacy from 1999 until its closure in 2014 – moved to dismiss, arguing that Pharmacy’s business accounted for a comparatively small slice of ABC’s total business.

Four red flags

In his opinion, Vice Chancellor Glasscock said the key to establishing that officers and directors showed bad faith in utterly failing to supervise Pharmacy so that it would operate within the law and the regulations of the pharmaceutical industry was the proof that they failed to respond to four critical “red flags:”

1. On September 11, 2017, the United States Department of Justice filed a Criminal Information against Pharmacy and its parent, charging that the repackaging program illegally introduced misbranded drugs into interstate commerce under the Food and Drug Commission Act under 21 U.S.C. §§ 33c1(a), 333(a)(1), 352(o), and 360, and 18 U.S.C. §§ 2, 3551, et seq. On September 27, 2017 Pharmacy and its parent pleaded guilty to violating the FDCA and the companies paid $260 million to the Department of Justice, consisting of a $208 million criminal fine and a criminal money forfeiture of $52 million ABC had obtained from unlawful sales of pre-filled syringes.

During the relevant time period, the ABC board did not set aside a portion of board meetings devoted to drug safety and compliance and the Criminal Information served as the first disclosure to ABC’s stockholders of the alleged misconduct that occurred at Pharmacy. The board did not act or even discuss what to do, the court said.

2. In 2007 ABC, engaged Davis Polk & Wardwell to undertake an assessment of the adequacy of ABC’s compliance program, to recommend improvements and to report the results of the assessment — that Specialty was not integrated into ABC’s compliance and reporting function and that oversight responsibilities were being left to officers and directors of the various ABC subsidiaries. But the ABC board and its committees allegedly never followed up on any of the recommendations that came from the report.

3. Michael Mullen was an executive at Specialty beginning in 2003 and promoted to COO of Specialty in September 2009, where he was responsible for Specialty’s eight business units including Pharmacy. By January 2010, Mullen had identified significant issues across all of Specialty’s business units, including serious issues with Specialty’s oncology business model that created regulatory exposure. After months of raising concerns about Specialty’s oncology business and lobbying for ABC to address the compliance issues at Specialty, Mullen was terminated on April 8, 2010, and management never told the board about Mullen’s compliance concerns or firing. The reporting system failed completely, the court said.

Mullen filed a qui tam complaint under seal in federal district court in New York on October 21, 2010, but no remedial action was taken against any employee for the misconduct identified in Mullen’s qui tam complaint, and appears not to have even been discussed by the board, the vice chancellor said.

4. In January 2014, ABC and Specialty ended the Pre-Filled Syringe Program by closing the Oncology facility in Dothan, Alabama. The board’s audit committee’s first mention of ending the Pre-Filled Syringe Program was on April 23, 2014, where the Audit Committee was informed that “the [Specialty] operating income included the loss of income from a [Specialty] pharmacy closure in Dothan, Alabama.” No board discussion occurred regarding why the Oncology facility was closing.

Ruling based on Rales

Vice Chancellor Glasscock ruled that because the plaintiffs challenged board inaction, and not a specific board decision, demand futility is analyzed under the test articulated in Rales v. Blasband, 634 A.2d 927 (Del. 1993). Under that standard, the high probability that the majority of the directors face liability for their failure to oversee ABC’s legal operation means they could not have made an independent or objective decision on any charges against the directors and officers, so pre-suit demand would have been futile under either prong of Caremark he said.

Under “prong one,” of Caremark, “a director may be held liable if she acts in bad faith in the sense that she made no good faith effort to ensure that the company had in place any system of controls.” A “prong two” claim, on the other hand, arises where “having implemented such a system or controls, [the directors] consciously failed to monitor or oversee its operations thus disabling themselves from being informed of risks or problems requiring their attention,” the Vice Chancellor’s decision says.

He found that the importance of the directors’ attention to the company’s “mission critical” regulatory issues is outlined in the Delaware Supreme Court’s Marchand v. Barnhill decision because the ABC board’s failure to both institute monitoring systems and to implement them exposed the company to significant liability. Marchand v. Barnhill 212 A.3d 805 (Del. 2019).

Time-will-tell take-aways?

A possible time-will-tell take-away from this opinion could make it easier for Caremark claim plaintiffs to survive the pre-suit demand test. Jurists and corporate attorneys may minimize the impact of this ruling if most of them see it as an outlier produced mainly by unusual facts.

But most may read it as a signal from the nation’s preeminent business court that in this post-Covid world, failure-to-supervise claims involving the director response to red-flagged problems with mission-critical operations at closely-regulated health-related businesses deserve increased scrutiny – especially at the crucial pleading stage.

And some may even see the need to apply that increased scrutiny to director decisions in suits against any closely-regulated business, especially one that impacts human health.

 

A recent Court of Chancery letter ruling provides useful definitions and related statements of Delaware contract law in connection with issues that arose over an asset purchase agreement. In CHS/Community Health Systems, Inc. v. Steward Health Care System LLC, C.A. No. 2019-0165-JRS (Del. Ch. Aug. 21, 2020), the following statements of law provided by the court are useful for corporate and commercial litigators:

  • The court defined the standard for determining whether a party may be a third-party beneficiary to a contract, and denied a motion to dismiss even though the agreement at issue disclaimed an intent that there be any such beneficiary. See footnote 32 and accompanying text.
  • Also useful for the toolbox of Delaware litigators is the court’s description of those circumstances when an unjust enrichment claim may survive a motion to dismiss, or when a breach of contract claim may foreclose that cause of action. See footnote 44 and accompanying text.
  • When a contract is unambiguous a motion to dismiss may be timely. Otherwise, if extrinsic evidence is needed, an MTD may be premature. See Slip op. at 8.