The Delaware Supreme Court has announced a revised standard for an important aspect of corporate litigation: the analysis of pre-suit demand futility for purposes of pursuing a derivative stockholder claim, in United Food and Commercial Workers Union and Participating Food Industry Employers Tri-State Pension Fund. v. Zuckerberg, No. 404, 2020 (Del. Sept. 23, 2021).

Before this decision was issued, corporate litigators would need to decide whether the Aronson test or the Rales test should apply to the analysis, but this decision affirmed the Court of Chancery opinion which has questioned the continued utility of the Aronson test.

I cannot improve on the scholarly commentary and insights about this ruling provided by one of Delaware’s favorite corporate law scholars, so I provide below the learned analysis by Prof. Stephen Bainbridge on this case from his eponymous blog:

 

Major Delaware Corporate Law Development: Delaware Supreme Court “Revises” Aronson Standard for Demand Futility

United Food and Commercial Workers Union v. Zuckerberg, et al., 2021 WL _______ (Del. Sep. 23, 2021)

Background

Shareholder litigation comes in two possible forms. Direct” shareholder suits arise out of causes of action belonging to the shareholders in their individual capacity. It is typically premised on an injury directly affecting the shareholders and must be brought by the shareholders in their own name. In contrast, a “derivative” suit is one brought by the shareholder on behalf of the corporation. The cause of action belongs to the corporation as an entity and arises out of an injury done to the corporation as an entity. The shareholder is merely acting as the firm’s representative. Our focus here is on derivative litigation.

The law governing derivative litigation has many complexities, most of which result from the collision of two basic principles. On the one hand, the derivative cause of action belongs to the corporation. The board of directors is charged with running the corporation and therefore ought to control corporate litigation. On the other hand, when it is the directors or their associates who are on trial, we may not trust them to make unbiased decisions.

Because the derivative suit is premised on a cause of action belonging to the corporation, one might assume that the corporation would simply bring the lawsuit itself. Derivative suits in fact are relatively rare; most corporate lawsuits are brought by the entity, rather than its shareholders. The derivative suit, of course, was devised so as to permit shareholders to seek relief on behalf of the firm in those cases where the corporation’s management for some reason elected not to pursue the claim. Logically, however, it would seem that the corporation should be given an opportunity to decide whether to bring suit before a shareholder is allowed to file a derivative suit.

Accordingly, both Delaware Rule of Civil Procedure 23.1 and the essentially identical Federal Rule 23.1 provides that shareholders may not bring suit unless they first make demand on the board of directors or demand is excused.[1] The requisite demand can take any form, although most jurisdictions require that it be in writing. The demand need not be in the form of a pleading nor a detailed as a complaint, but rather simply must request that the board bring suit on the alleged cause of action.

Although the demand requirement looks like a mere procedural formality, it has evolved into the central substantive rule of derivative litigation.[2] The foundational question in derivative litigation is the extent to which the corporation, acting through the board of directors or a committee thereof, is permitted to prevent or terminate a derivative action. Put another way, who gets to control the litigation—the shareholder or the corporation’s board of directors? Curiously, the answer to that question depends mainly on the procedural posture of the particular case with respect to the demand requirement. More precisely, it depends on whether demand is required or excused as futile.

Delaware requires demand in all cases except those in which it is excused on grounds of futility. In the seminal Aronson v. Lewis decision, the Delaware Supreme Court set forth the following test for demand futility:

[T]he Court of Chancery in the proper exercise of its discretion must decide whether, under the particularized facts alleged, a reasonable doubt is created that: (1) the directors are disinterested and independent and (2) the challenged transaction was otherwise the product of a valid exercise of business judgment.[3]

The Court’s use of a reasonable doubt standard has been the subject of much criticism:

The reference to “reasonable doubt” summons up the standard applied in criminal law. It is a demanding standard, meaning at least a 90% likelihood that the defendant is guilty. If “reasonable doubt” in the Aronson formula means the same thing as “reasonable doubt” in criminal law, then demand is excused whenever there is a 10% chance that the original transaction is not protected by the business judgment rule. Why should demand be excused on such a slight showing? Surely not because courts want shareholders to file suit whenever there is an 11% likelihood that the business judgment rule will not protect a transaction. Aronson did not say, and later cases have not supplied the deficit. If “reasonable doubt” in corporate law means something different from “reasonable doubt” in criminal law, however, what is the difference?, and why use the same term for two different things?[4]

In defense of the reasonable doubt standard, the Delaware Supreme Court rather weakly argued that “the term is apt and achieves the proper balance.”[5] Somewhat more helpfully, the court rephrased the test by reversing it: “the concept of reasonable doubt is akin to the concept that the stockholder has a ‘reasonable belief’ that the board lacks independence or that the transaction was not protected by the business judgment rule.”

The Aronson standard proved awkward in some cases, such as when there had been a turnover in board composition, where the complaint alleged inaction rather than action, and so on. In Rales v. Blasband, Plaintiff brought a double derivative suit on behalf of a parent corporation with respect to the sale of subordinated debentures by its wholly owned subsidiary. Because the derivative suit did not challenge a decision by the parent corporation’s board, the court held that the Aronson standard did not apply:

Instead, it is appropriate in these situations to examine whether the board that would be addressing the demand can impartially consider its merits without being influenced by improper considerations. Thus, a court must determine whether or not the particularized factual allegations of a derivative stockholder complaint 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 a demand. If the derivative plaintiff satisfies this burden, then demand will be excused as futile.[6]

The court noted three scenarios in which this test is to be used in lieu of the Aronson standard: (1) where a majority of the board that made the challenged transaction has been replaced by disinterested and independent members; (2) where the litigation arises out of some transaction or event not involving a business decision by the board; and (3) where the challenged decision was made by the board of a different corporation.

As former Delaware Chief Justice Leo Strine explained in an opinion written earlier in his career during his stint as a Vice Chancellor:

At first blush, the Rales test looks somewhat different from Aronson . . .. [The Rales] inquiry makes germane all of the concerns relevant to both the first and second prongs of Aronson. For example, in a situation when a breach of fiduciary duty suit targets acts of self-dealing committed, for example, by the two key managers of a company who are also on a nine-member board, and the other seven board members are not alleged to have directly participated or even approved the wrongdoing (i.e., it was not a board decision), the Rales inquiry will concentrate on whether five of the remaining board members can act independently of the two interested manager-directors. This looks like a first prong Aronsoninquiry.

When, however, there are allegations that a majority of the board that must consider a demand acted wrongfully, the Rales test sensibly addresses concerns similar to the second prong of Aronson. To wit, if the directors face a “substantial likelihood” of personal liability, their ability to consider a demand impartially is compromised under Rales, excusing demand.[7]

In United Food and Com. Workers Union v. Zuckerberg,[8] the Delaware Chancery Court (per Vice Chancellor J. Travis Laster), took note of the criticism that Aronson has been subject to over the years and proposals that the courts should abandon Aronson and adopt Rales as the general standard. In UFCWU, VC Laster proposed just such a move:

Both [the Aronson and Rales] tests remain authoritative, but the Aronson test has proved to be comparatively narrow and inflexible in its application, and its formulation has not fared well in the face of subsequent judicial developments. The Rales test, by contrast, has proved to be broad and flexible, and it encompasses the Aronson test as a special case.[9]

VC Laster went on to explain that:

In using the standard of review for the challenged transaction as a proxy for the risk of director liability and hence the test for demand futility, Aronson was a creature of its time. Subsequent jurisprudential developments severed the linkage between these concepts. Under current law, the application of a standard of review that is more onerous than the business judgment rule does not render demand futile. Similarly, the availability of exculpation means that a standard of review that is more onerous than the business judgment rule may not result in a substantial likelihood of liability.[10]

Laster reviewed these changes in detail, explaining how they had called into question the continuing utility of Aronson.

In addition to its declining doctrinal relevance, the Aronson test has always been an awkward way of getting at the core problem in the derivative suit context. Recall that we are dealing here not with a lawsuit brought to redress an injury done to the shareholder but rather one done to the corporate entity. The board of directors is charged with running the corporation and therefore ought to control corporate litigation. On the other hand, when it is the directors or their associates who are on trial, we may not trust them to make unbiased decisions. Consequently, the law governing derivative litigation must balance the competing policies of deference to the board’s decision-making authority and the need to hold erring directors accountable.

The core question thus is: Do we trust the board of directors to make a good faith decision about the merits of the lawsuit in question. If so, the board should be allowed to control the case. If not, the shareholder should be allowed to go forward.

Aronson gets at that question only indirectly. In contrast, as Laster explained, Rales does so directly:

The significant advance made by Rales was to refocus the inquiry on the decision regarding the litigation demand, rather than the decision being challenged. . . . The Rales decision thus asked directly “whether the board that would be addressing the demand can impartially consider its merits without being influenced by improper considerations.”

Under Rales, a director is disqualified from exercising judgment regarding a litigation demand if the director was interested in the alleged wrongdoing, such as when the director received a personal benefit from the wrongdoing that was not equally shared from the stockholders. A director also is disqualified from exercising judgment regarding a litigation demand if another person was interested in the alleged wrongdoing, and the director lacks independence from that person. Although these aspects of the Rales inquiry look to the relationship between the alleged wrongdoing and the directors considering the litigation demand, they do so for purposes of analyzing the directors’ ability to evaluate the litigation demand, not to determine the standard of review that would apply to the alleged wrongdoing.[11]

On appeal, the Delaware Supreme Court (per Justice Montgomery-Reeves) affirmed.[12]

Facts

In 2016, Facebook proposed a stock reclassification that would allow founder and controlling shareholder Mark Zuckerberg to dispose a substantial amount of his shares while still retaining voting control of the company. Numerous shareholder suits were challenging the proposal, which were consolidated into a single class action. Shortly before the trial was scheduled to begin, Facebook withdrew the proposal and settled the case. Facebook spent almost $22 million defending the class action, including over $17 million on attorneys’ fees. The settlement included payments to the plaintiffs’ lawyers of over $68 million.

A Facebook shareholder, the United Food and Commercial Workers Union and Participating Food Industry Employers Tri-State Pension Fund (UFCWU), filed a derivative suit claiming that Facebooks’ board of directors “breached their fiduciary duties of care and loyalty by improperly negotiating and approving” the reclassification. The new suit was brought derivatively on behalf of the corporation to recover the money Facebook had spent defending and settling the original class action.

The plaintiff did not make demand before filing the derivative suit. When the defendants moved to dismiss the suit for failure to do so, plaintiff claimed that demand should be excused as futile. VC Laster granted the motion. Plaintiff appealed.

Held

Affirmed.

Reasoning

The Supreme Court emphasized the centrality of a demand requirement with teeth as a gateway to derivative litigation:

[T]he demand requirement is not excused lightly because derivative litigation upsets the balance of power that the DGCL establishes between a corporation’s directors and its stockholders. Thus, the demand-futility analysis provides an important doctrinal check that ensures the board is not improperly deprived of its decision-making authority, while at the same time leaving a path for stockholders to file a derivative action where there is reason to doubt that the board could bring its impartial business judgment to bear on a litigation demand.[13]

(This is, by the way, a point I made at some length in my book Corporation Law and Economics at 399-404, in which I discussed the application of my director primacy theory to derivative litigation.)

In operationalizing that policy, the Court noted that there had been an important doctrinal shift since Aronsonwas decided; namely, the adoption of FGCL § 102(b)(7), which allows corporations to adopt provisions in their articles of incorporation exculpating monetary liability for duty of care claims against directors. Almost all public Delaware corporations have adopted such provisions.

Accordingly, this Court affirms the Court of Chancery’s holding that exculpated care claims do not satisfy Aronson’s second prong. This Court’s decisions construing Aronson have consistently focused on whether the demand board has a connection to the challenged transaction that would render it incapable of impartially considering a litigation demand. When Aronson was decided, raising a reasonable doubt that directors breached their duty of care exposed them to a substantial likelihood of liability and protracted litigation, raising doubt as to their ability to impartially consider demand. The ground has since shifted, and exculpated breach of care claims no longer pose a threat that neutralizes director discretion.[14]

After disposing of plaintiff’s various objections to that conclusion, the Court turned to the question “whether the three-part test for demand futility the Court of Chancery applied below is consistent with Aronson, Rales, and their progeny.”[15] VC Laster’s version of the Rales test stated:

(i) whether the director received a material personal benefit from the alleged misconduct that is the subject of the litigation demand;

(ii) whether the director would face a substantial likelihood of liability on any of the claims that are the subject of the litigation demand; and

(iii) whether the director lacks independence from someone who received a material personal benefit from the alleged misconduct that is the subject of the litigation demand or who would face a substantial likelihood of liability on any of the claims that are the subject of the litigation demand.[16]

Oddly, although the test is phrased in the conjunctive (“and”), it seems clear that the court intends it to be applied in the disjunctive: “If the answer to any of the questions is ‘yes’ for at least half of the members of the demand board, then demand is excused as futile.”[17]

The Supreme Court adopted “the Court of Chancery’s three-part test as the universal test for assessing whether demand should be excused as futile,”[18] explaining:

The purpose of the demand- futility analysis is to assess whether the board should be deprived of its decision-making authority because there is reason to doubt that the directors would be able to bring their impartial business judgment to bear on a litigation demand. That is a different consideration than whether the derivative claim is strong or weak because the challenged transaction is likely to pass or fail the applicable standard of review. It is helpful to keep those inquiries separate.[19]

The court concluded by denying that this amounted to a dramatic change in the law, arguing that “because the three-part test is consistent with and enhances Aronson, Rales, and their progeny, the Court need not overrule Aronson to adopt this refined test, and cases properly construing Aronson, Rales, and their progeny remain good law.”[20]

 

[1] Federal Rule 23.1 contemplates that demand may be made on shareholders in appropriate cases. A few jurisdictions require demand on shareholders, at least in some cases. See, e.g., Heilbrunn v. Hanover Equities Corp., 259 F.Supp. 936 (S.D.N.Y.1966) (demand on shareholders excused where wrongdoers hold a majority of corporation’s stock); Mayer v. Adams, 141 A.2d 458 (Del.Supr.1958) (demand on shareholders excused where alleged wrong could not be ratified by shareholders).

[2] See Levine v. Smith, 591 A.2d 194, 207 (Del.1991) (“The demand requirement is not a ‘mere formalit[y] of litigation,’ but rather an important ‘stricture[ ] of substantive law.’ ”); see also Barr v. Wackman, 368 N.Y.S.2d 497, 505 (1975) (“demand is generally designed to weed out unnecessary or illegitimate shareholder derivative suits”).

[3] Aronson v. Lewis, 473 A.2d 805, 814 (Del.1984).

[4] Starrels v. First Nat’l Bank of Chicago, 870 F.2d 1168, 1175 (7th Cir.1989) (Easterbrook, J., concurring) (citations omitted).

[5] Grimes v. Donald, 673 A.2d 1207, 1217 (Del.1996).

[6] Rales v. Blasband, 634 A.2d 927, 934 (Del.1993).

[7] Guttman v. Huang, 823 A.2d 492, 501 (Del. Ch. 2003).

[8] 250 A.3d 862 (Del. Ch. 2020).

[9] Id. at 877.

[10] Id. at 880.

[11] Id. at 887.

[12] United Food and Commercial Workers Union v. Zuckerberg, et al., No. 2018-0671-JTL, 2021 WL _______ (Sep. 23, 2021).

[13] Id. at 22.

[14] Id. at 31.

[15] Id. at 37.

[16] Id. at 37-38 (emphasis supplied).

[17] Id. at 41. Interestingly, the same problem arose in Aronson, where the test was phrased in the conjunctive. There was some confusion as a result as to whether a plaintiff needed to create a reasonable doubt as to both prongs. In its subsequent Levine v. Smith opinion, 591 A.2d 194 (Del.1991), the court made clear that the test is in the disjunctive, such that satisfying either prong suffices. Id. at 205.

Note that the United Food and Commercial Workers Union court used the phrase “at least half” rather than “a majority.” See, e.g., Kohls v. Duthie, 791 A.2d 772 (Del.Ch.2000) (holding that demand was excused even though only half of the board was deemed incapable of impartially assessing the litigation).

[18] United Food and Commercial Workers Union, at 38.

[19] Id. at 39.

[20] Id. at 40.

A recent decision by the Delaware Court of Chancery is useful for litigators who need to know what remedies are available when an opposing party does not provide documents required by court-ordered deadlines: Dolan v. Jobu Holdings, LLC, C.A. No. 2020-0962-JRS (Del. Ch. Sept. 2, 2021).

Quick Overview of Case:

In connection with a summary proceeding in a books and records action pursuant to Section 18-305 of the Delaware LLC Act, certain tax returns were required to be produced pursuant to a Stipulation and Consent Order. The deadlines were not met. Notwithstanding various excuses provided by the defendant and the accountant for the defendant who was preparing the tax returns that were required to have been submitted, the plaintiff filed a motion to show cause why the defendant should not be held in contempt for violating the court-ordered deadlines.

Standard for Civil Contempt:

The court recited the standard for holding a party in civil contempt for not complying with the court order as follows:

“To establish civil contempt, the petitioning party must demonstrate that the contemnors violated an Order of this Court of which they had notice and by which they were bound (footnotes omitted). The petitioning party bears the burden of showing contempt by clear and convincing evidence; only upon carrying that burden will the ‘burden . . . shift to the contemnors to show why they were unable to comply with the order. Importantly, to justify a citation for contempt, the violation must not be a mere technical one, but must constitute a failure to obey the Court in a meaningful way. Further, even where there has been a violation, the Court will consider good faith efforts to comply with the order, or to remedy the consequences of non-compliance. Resolution of a motion to show cause why a party should not be held in contempt is addressed to the discretion of this Court.’” (citations omitted.)

Court’s Reasoning:

The Court determined that the conduct of the defendants in not meeting the Court-imposed deadlines did not rise to the level of contempt because the defendants’ actions did not constitute a failure to obey the court in a meaningful way. Although there was a technical violation, the Court reasoned that in order for the failure to be “meaningful,” the defendants would have needed to act in “willful disregard of the Order or have refused to make good faith efforts to comply.” Slip op. at 5.

The Court also imposed a new deadline which I will refer to as the “really, really final deadline” which the Court explained would not be extended “absent good cause shown.” See footnote 12.

Takeaway:

Most readers have encountered the frustration caused by an opposing party not meeting deadlines, which–especially in a summary proceeding or an expedited proceeding–makes it more difficult for the counterparty to meet their own deadlines, and “jams-up” other deadlines in the case when the opposing party does not “keep on schedule.” This decision exemplifies the difficulty in enforcing even deadlines that are part of a court order, but litigators should keep decisions like this in their toolbox so that in appropriate circumstances even if motion practice is not a panacea, there may be reputational reasons for the nonconforming party to comply, perhaps, in the face of a reluctant motion.

 

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 ruled Boeing Company directors must face shareholder charges that they breached their oversight duty by insulating themselves from safety problems with the new 737 MAX and ignoring red flag warnings of deadly stability defects that crashed two of the jetliners within five months. In Re The Boeing Company Derivative Litigation, No. 2019-0907-MTZ opinion issued, (Del. Ch. Sept. 9, 2021).

In her Sept. 9 opinion, Vice Chancellor Morgan Zurn found pension fund plaintiffs’ director oversight claims met the tough pleading standards of the Delaware Supreme Court’s milestone Marchand ruling with well-supported allegations that a majority of the directors are likely liable for Boeing’s billions of dollars in losses and penalties and can’t be entrusted to bring breach-of-duty charges. Marchand v. Barnhill, 212 A.3d 805 (Del. 2019)

Marchand was the high court’s preeminent interpretation of Chancellor William Allen’s 1996 pioneering In re Caremark International ruling that set standards for shareholder plaintiffs to recover on behalf the corporation itself in the rare oversight 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.” In re Caremark Int’l Inc. Derivative Litig., 698 A.2d 959 (Del. Ch. 1996).

Vice Chancellor Zurn’s ruling repeatedly pointed to the Marchand standards in finding that Boeing’s directors:

1. Got no regular safety information on the 737 MAX or any of its planes due to their “complete failure” to establish a committee or regular board reports on safety issues,
2. After the first crash, did not immediately investigate what caused the 737 MAX to repeatedly push its nose down in a series of disastrous dives at low speeds and instead virtually ignored the problem even though safety was a “mission critical” area,
3. Intentionally misled federal regulators about the scope and seriousness of a computer pilot training program meant to help them use software that would allegedly minimize nose-down dives,
4. Allegedly lied to the public and regulators about how comprehensive, good faith and quickly implemented their post-crash safety program was.
5. Never pressed the CEO for more information or questioned his conclusions when he repeatedly told the board the 737 MAX was safe and blamed the crashes on pilot and maintenance errors.

However, she found insufficient proof for charges that Boeing’s officers stifled defect reports and that the board bought ex-CEO Dennis Muilenburg’s silence about their liability with an overly rich exit package.

Some legal experts have questioned whether Vice Cancellor Zurns’ opinion fits into what they see as a trend of recent rulings that have allegedly made it less difficult to meet what the Delaware courts have traditionally called the “onerous” pleading standards of a Caremark duty claim.

Background
Two public pension funds were the co-lead plaintiffs in a shareholder suit that claimed Boeing’s directors were liable for lax safety that caused two crashes of the new 737 MAX jetliner, killing all aboard both planes — which were grounded by federal regulators for 20 months with large financial losses. They contended that the directors were too conflicted by their likelihood of liability to press claims, giving the shareholders standing as derivative plaintiffs.

Was demand futile?
Defendants’ motion to dismiss argued that plaintiffs could not meet the very high hurdle pleading standards for their Caremark claims but Vice Chancellor Zurn found the amended complaint meets both prongs of the threshold demand requirements of Court of Chancery Rule 23.1 under the seminal Rales v. Blasband, 634 A.2d 927 (Del. 1993) opinion “and is therefore permitted to assume control of a claim belonging to the corporation.” She found demand on the board would have been futile because there was adequate support for charges that a majority of the directors lacked both independence and disinterest.

The directors “face a substantial likelihood of liability for failure to fulfill their oversight duties under the standards set forth in Caremark, as applied by the Delaware Supreme Court in Marchand, the vice chancellor wrote, adding that the complaint adequately alleges bad faith, “a necessary condition to director oversight liability.”

In response to defendants’ argument that they met the Federal Aviation Administration’s requirements for certification of the plane and its accompanying training and operation program, the court said, “under Marchand, minimal regulatory compliance and oversight do not equate to a per se indicator of a reasonable reporting system.”

Takeaways
Legal scholars may debate for some time to come whether Boeing and/or any of its predecessors in the past few years used degraded pleading requirements — and what the resultant effect might have been on the “onerous” Caremark standard. However, readers are referred to a previous synopsis on these pages of  another Caremark decision with an interesting similarity. Teamsters Local 443 Health Services & Insurance Plan et al. v. Chou, et al., No. 2019-0816-SG opinion issued (Del. Ch. Aug. 24, 2020).

In that opinion, the Chancery Court found that shareholder plaintiffs also passed the Caremark pre-suit demand test because they adequately alleged that the defendant pharmaceutical company’s directors insulated themselves from bad news and turned a blind eye to red flags concerning a subsidiary’s criminal enterprise of dangerous cancer drug repackaging.

The takeaway from that blog post speculated that, “most may read the ruling 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.”

In my most recent ethics column appearing in the current issue of The Bencher, the publication of the American Inns of Court, I highlighted a recent Delaware Supreme Court decision which confirmed prior decisions that established Delaware’s High Court as the only body in the First State with the authority  to enforce the Delaware rules of ethics applicable to lawyers, with a few exceptions. It reversed a trial court decision that imposed fees on a lawyer who engaged in “ungentlemanly” communications with other counsel.

In a seminal decision that has already been the subject of extensive scholarly commentary within the few days since its issuance, the Delaware Supreme Court overruled its 2006 decision in the Gentile case. That decision held that some stockholder claims can be both direct and derivative. New Delaware law on this topic was announced in Brookfield Asset Management, Inc. v. Rosson [TerraForm],  No. 406, 2020 (Del. Sept. 20, 2021).

The Harvard Law School Forum on Corporate Governance, on which I have published several articles, has a helpful overview of the case.

I typically favor on these pages those Delaware corporate and commercial decisions that are not already the subject of extensive commentary elsewhere, with some exceptions. So many other qualified academics and practitioners have already written about this case, that I’ll defer further comment and direct readers to the abundant analysis already available elsewhere.

 

 

 

A recent ruling of the Delaware Court of Chancery provides a useful refresher on the standards that must be met for various exceptions or waivers of the attorney/client privilege to apply. In Drachman v. BioDelivery Sciences International, Inc., C.A. No. 2019-0728-LWW (Del. Ch. Aug. 25, 2021), the Court addressed the following theories which, if applicable, could prevent one from enjoying the protection of the attorney/client privilege, and might lead to the disclosure of otherwise privileged communications:

  • The Garner doctrine;
  • Crime-Fraud exception;
  • At-Issue exception (placing the privileged document in question “at issue” or using it as both a sword and a shield)

Selected Key Facts

The case involves a stockholder claim that the approvals required by DGCL Section 242 were not obtained for amendments to the corporate charter, and that the related actions of the board of directors were a breach of their fiduciary duties.

Selected Highlights

The Court began with the basics. Chancery Rule 26(b) essentially allows discovery of relevant data that is proportional to the needs of the case. But Delaware Rule of Evidence 502(b), which codifies the attorney/client privilege, insulates from discovery “confidential communications made for the purpose of facilitating the rendition of professional legal services to the client.”

Garner Doctrine

Sometimes referred to as the “fiduciary exception”, the Court notes that this is not actually an exception to the privilege rule. See n. 34. When applicable it provides that “when a stockholder sues a fiduciary for behavior inimical to the stockholder’s interests, she may invade the corporation’s privilege upon a showing of “good cause”.

There are 9 enumerated factors that must be considered, but the first two are “gatekeepers” and the parties in this case focused on the first three factors. Although the party who moved to compel “cleared the first two gates”, the movant did not demonstrate that the data was unavailable from other sources (discovery was in the early stages) or that the data was needed to prove her claim. See Slip op. at 10-17.

The At-Issue Exception

The Court noted that whether this is an exception or a waiver deserves attention but is not determinative in practice. See n. 62. After a thorough analysis and application of the facts, the Court explained why the moving party did not meet the threshold for this exception to apply.

Crime-Fraud Exception

Any reader who needs to know the necessary requirements to determine if this exception applies, should read pages 23 to 26 of this letter ruling to understand why the moving party did not persuade the Court that this exception applied.

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 refused Charter Communications Inc. investors’ bid to amend their breach-of-duty complaint so as to add previously-dismissed defendant Liberty Broadband Corp. based on newly-discovered evidence because plaintiffs failed to clear a “high bar” to reverse such a with-prejudice dismissal. Sciabacucchi, et al. v. Malone et al., No. 11418-VCG opinion issue (Del. Ch. Aug. 18, 2021). The Court also clarified that the “default rule” is that dismissals under Rule 12(b)(6) are “with prejudice”.

Vice Chancellor Sam Glasscock’s August 18 opinion allowed the motion to amend but only as to a new aiding and abetting charge not previously dismissed. As to the other charges he said because plaintiffs had failed to preserve the dismissal as “without prejudice” under Court of Chancery Rule 15(aaa), they could not replead that decision unless they could show “clear error, injustice, or a change in circumstances.”

The ruling contained a clear warning to Chancery Court plaintiffs against “the pernicious practice of using multiple motions to dismiss as honing stones against which to sharpen a claim, resulting potentially in a viable cause of action, but at the expense of the party opponent and the Court.”

The vice chancellor said after Broadband’s dismissal, plaintiffs claimed Broadband should be added to the complaint because they unearthed evidence that “a record will develop that may implicate defendants against whom the plaintiff has failed to state a claim in the initial complaint,” but plaintiffs never sought dismissal without prejudice and they have failed to clear the resulting “high bar.”

Background

Plaintiff shareholders’ 2015 complaint challenged as self-dealing certain transactions between Charter and Broadband undertaken to facilitate two acquisitions which are, themselves, not challenged. But necessary to any self-dealing charge, Vice Chancellor said, is the allegation that defendant director John Malone and now non-party Broadband together controlled Charter, at the very least, in connection with the Broadband transactions.

In two previous opinions, he found that although Malone and Broadband might technically combine to exert control contractual restrictions on them meant that they functionally could not exercise actual control and dismissed Broadband and part of the complaint.

Plaintiffs’ motion argued that discovery has revealed new information that supports a re-assertion of the allegation that Broadband and Malone were controllers and should allow them to revive two counts of the complaint which allege breaches of duty against Malone and Broadband.

The August 18 opinion

In the August 18 opinion, the court said since the dismissal was with prejudice under Rule 15(aaa) the plaintiff may replead only “if it can demonstrate that a compelling reason to disregard the law of the case exists.”

The Vice Chancellor pointed to Toro Co. v. White Consol. Indus., Inc., 383 F.3d, 1336 (Fed. Cir. 2004), where “The Federal Circuit has noted that “[a] departure from law of the case generally requires the discovery of new and material evidence not presented in the prior action or an intervening change of controlling legal authority, or [a showing that] the prior decision is clearly incorrect and its preservation would work a manifest injustice.”

He said even though his previous dismissals were not explicitly “with prejudice” under Rule 15(aaa), “ the default rule is that dismissals under Rule 12(b)(6) are with prejudice. That ruling controls, as law of the case.”

Plaintiffs are left with a high bar which they cannot clear with the three claims of new evidence they present, the vice chancellor said, because:

1. Although Malone testified that he had ‘soft control’ over Charter it was in context of and in contrast to a discussion about so-called “hard control” where he and his family would control of the stock,
2. The de facto veto Broadband held over two key acquisitions in the challenged deal was not a contractual right of Broadband, or any other defined right to veto the transactions, but was procedural.
3. Broadband’s designees on the Charter board allegedly voted in favor of the Broadband Transactions but at the time, Broadband had the right to designate four of ten board members—less than a majority.

The aiding and abetting exception

As to the aiding and abetting claims plaintiffs proposed to add against Broadband the court said the law of the case rule does not apply since they were not in the original complaint and there was no bad faith, undue delay, dilatory motive, or repeated failures to cure by prior amendment,” the court said.

The court found no futility since the aiding and abetting charges “rest on substantially the same allegations that previously supported the control allegations” and said the defendants were not prejudiced by undue delay. The vice chancellor noted that even though it has not been a defendant for three years and has been only marginally involved in discovery as a non-party, adding Broadband to the aiding and abetting charges is a “closer question than the other defendants since:

It is represented by the same lawyers who have represented Malone,
It is controlled by Malone and is a significant stockholder of Charter,
It was previously on notice that it was involved in this case, even as a non-party, and
It ought to have been on notice that it could be open to other claims stemming from the same facts

Vice Chancellor Glasscock granted that part of the motion while denying the bid to add Broadband as a defendant in the original claims based on new evidence.

A recent Delaware Court of Chancery decision must be read by anyone interested in the latest iteration of Delaware law concerning when a non-signatory may be bound by a forum selection clause in an agreement. In Florida Chemical Company, LLC v. Flotek Industries, Inc., C.A. No. 2021-0288-JTL (Del. Ch. Aug. 17, 2021), the court provides the most thorough analysis of the titular topic that this reader is aware of, with scholarly insights and copious citations that explain the theoretical underpinnings that support a decision to bind a non-signatory to a forum selection clause, and the prerequisites for doing so.

The court granted an anti-suit injunction to prevent litigation from proceeding in Texas that was contrary to the forum selection clause to which the court found both a parent corporation and its wholly-owned subsidiary to be bound, based on the extensive reasoning provided in this opinion.

Issue Presented:

The issue presented in this decision was whether a non-signatory can be bound to a forum selection clause based on equitable estoppel or promissory estoppel. The court needed to determine whether the Flotek Sub was bound by the agreement signed by the Flotek Parent company before deciding if a particular issue was covered by the forum selection clause. The court conducted a claim-by-claim analysis to determine if the claims filed in another forum were covered by the forum selection clause at issue.

Key Facts:

The Flotek Parent in this case was a party to a Purchase Agreement with a Delaware forum selection clause. But the Flotek Subsidiary involved in this case was not a party to that agreement. Rather, the Flotek Sub was only a party to a separate Supply Agreement–that was referred to in the Purchase Agreement as an exhibit. The Purchase Agreement’s Delaware forum selection provision covered disputes related to other agreements such as the Supply Agreement. The supply agreement did not contain a forum selection provision.

Key Takeaways:

• It’s always useful to be reminded of the well-worn prerequisites for a preliminary injunction which the court provides at page 12.

• A reminder of basic Delaware contract interpretation principles is provided at pages 14-15.

• The court observes a truism of Delaware contract law that when more than one agreement is part of a unitary transaction, and when one contract is referred to in another, they are all interpreted as one contract. See Slip op. at 17-18. However, the court explained that this principle alone would not apply to require the claims of the Flotek Sub to be prosecuted in Delaware. See Slip op. at 32.

• The court restated a three-part test for determining when a non-signatory would be bound by a forum selection clause. See Slip op. at 33-48. The court modified the three-part test announced in the Chancery decision in Capital Group, 2004 WL 2521295, at *5. The first two parts of the test are as follows:

(i) the agreement contains a valid forum selection provision;

(ii) the non-signatory has a sufficiently close relationship to the agreement, either as an intended third-party beneficiary under the agreement or under principles of estoppel (such as equitable estoppel or promissory estoppel).

• The third element of the test described in the Capital Group case was the subject of extensive analysis and modification in this opinion.

• The court discussed the principles of estoppel that would bind a non-signatory to a forum selection clause: (i) a non-signatory accepted a direct benefit from the agreement; or (ii) a non-signatory had a close relationship to the agreement; a signatory to the agreement controlled the non-signatory; and the circumstances established that the signatory agreed to the forum selection provision on behalf of its controlled affiliate. Slip op. at 34. See also footnote 5. The court described the direct-benefit test as resting on principles of equitable estoppel, and the foreseeability test as introducing a measure of promissory estoppel. The court discussed at great length both the direct-benefit test and the foreseeability test. See Slip op. at 35-39.

• The third element in the Capital Group test, which the court modified, included the “same-agreement rule” that limited when a non-signatory would be bound, but that the Court of Chancery in this case decided not to follow.

• Among the extensive reasons given for not following that “same-agreement rule” in the third element of the Capital Group test are the following:

“That outcome [if the same-agreement rule applied] runs contrary to the underlying principles of estoppel that lead to the forum selection provision binding the non-signatory. When a non-signatory accepts a direct benefit under an agreement, principles of equitable estoppel demand that the non-signatory accept the burdens associated with that agreement, including a forum selection provision.”

Slip op. at 44.

• As applied to the facts of this case, the principles of estoppel called for enforcing the Delaware forum provision against the Flotek Sub. The Flotek Parent promised to litigate all claims arising out of or relating to the Supply Agreement in Delaware through the Delaware forum provision in the Purchase Agreement which encompassed related agreements among those claims that were within the forum selection provision. If the same-agreement rule were applied, it would permit the Flotek Parent to escape that promise.

• This decision interpreted the third element of the Capital Group test as asking whether the claims at issue fall within the plain language of a forum selection provision.

• This decision conducted a claim-by-claim analysis of the causes of action in a suit filed in Texas to determine whether they fell within the Delaware forum provision for purposes of an anti-suit injunction against the Flotek Parent. The court’s extensive reasoning explained why the Delaware forum selection provision also binds the Flotek Sub to the same degree as the Flotek Parent.

• The court’s holding also is based on the reasoning that it would allow parties to “enter into overarching forum selection provisions in a primary agreement without requiring that every controlled affiliate become a party to that agreement.”  The court further reasoned that the approach announced in this decision also promotes freedom of contract by enabling a controller to enter into an overarching forum selection provision and avoids the need for separate provisions in each agreement or the potentially cumbersome solution of having every controlled affiliate become a party to a primary agreement.

A recent Delaware Court of Chancery decision is noteworthy for its clarification of the nuanced contours of Delaware law regarding contractual restrictions on the perennial feature of Delaware commercial litigation, known as post-closing fraud claims. In Online Healthnow, Inc. v. CIP OCL Investments, LLC, C.A. No. 2020-0654-JRS (Del. Ch. Aug. 12, 2021), the court pronounced key statements of Delaware law on the titular topic in ruling on a Motion to Dismiss. The best way to begin short highlights of this 60-page decision is with a money quote:

“Under Delaware law, a party cannot invoke provisions of a contract it knew to be an instrument of fraud as a means to avoid a claim grounded in that very same contractual fraud.”

Slip. op. at 4. See generally seminal Chancery decision in Abry and its progeny, some of which have been highlighted on these pages.

Selected Key Facts:

Of course, a detailed grasp of the extensive factual recitations in this opinion are important for a full understanding of its holding, but a few selected key facts include the following: The Stock Purchase Agreement (SPA) involved in this post-closing dispute included representations that all tax returns of the seller were timely filed and accurate, and that there were no undisclosed liabilities. By contrast, the complaint alleges in extensive detail that large tax liabilities were not disclosed and that they were actively hidden during the due diligence period.

The buyer represented that it had accurate access to the records of the seller, and the SPA included anti-reliance provisions stating that the buyer was not relying on any representations other than those in the SPA.

The SPA also had detailed procedures to address post-closing purchase price adjustments, such as working capital. Disputes within the scope of that provision were to be submitted to an independent accounting firm.

But the parties contested what issues, or if all the issues, were required under the SPA to be submitted to the independent accounting firm, and whether the SPA allowed for any issues to be litigated in court.

Key Statements of Law:

• The court explained that Delaware public policy prohibits a party from contractually exempting itself for liability for fraud, or avoiding liability for intentionally or recklessly causing harm. Slip op. at 35-40. The opinion also relies on the reasoning in the Prairie Capital case, for example, with the following quote: “flesh and blood humans also can be held accountable for statements that they cause an artificial person, like a corporation, to make”. 132 A.2d at 59.

• The opinion includes a discussion of case law relating to the impact of “survival clauses” in connection with Delaware public policy against contractual barriers to fraud claims. Slip op. at 41-46.

• The weight of authority and public policy as explained in this decision, and applied to the facts of this case, prevented the use of the savings clause in the SPA to bar contractual fraud claims. Specifically, the court reasoned that:

“Sellers cannot invoke a clause in a contract allegedly procured by fraud to eviscerate a claim that the contract itself is an instrument of fraud.”

Slip op. at 52-53.

• The court also emphasized that the non-recourse provisions in the SPA could not be relied on to bar the fraud claim. Slip op. at 53-54.
• The parties agreed that the fraud claims were outside of the scope of the post-closing issues that the SPA required to be submitted to an accounting firm but disagreed on what other claims were required to be submitted to the accounting firm.

• In closing, the court determined that the scope of the fraud, if any, that occurred, was a ripe controversy for purposes of a declaratory judgment claim that must be decided by the court before the neutral accounting firm provided for in the SPA could begin its work. See footnote 217 and accompanying text (compiling cases on this topic regarding the scope of an accountant’s role to decide post-closing disputes).

A recent Chancery decision recounts the epic tale of a group of business partners who were longtime friends and who later accused each other, after forming a business together, of fraud and breach of fiduciary duty. In Stone & Paper Investors, LLC v. Blanch, C.A. No. 2018-0394-PAF (Del. Ch. July 30, 2021), the court describes in exhaustive detail the factual background involving detailed examples of funds invested in a company that were diverted for personal use instead of being applied for business purposes.

The opinion in this case should be read in its 108-pages of glory but for purposes of this short blog post, the most consequential aspects of the court’s legal reasoning that have the most widespread applicability include its discussion of the fiduciary duties of LLC Managers, where the LLC agreement does not waive those duties.

The court explains the well-known truism that under Delaware law, absent unambiguous waiver, fiduciary duties are imposed on LLC managers by default. See Slip op. at 73-75. The court observed that the LLC agreement in this case did limit personal liability–except that liability was not eliminated for “acts or omissions in bad faith or involving intentional misconduct or knowing violation of law or personal financial benefit to which the manager is not entitled.” After extensive reasoning, the court found that the breaches of fiduciary duty constituted intentional misconduct.

The court relied on the recent Chancery decision in Largo Legacy Group, LLC v. Charles, 2021 WL 2692426, at *13 (Del. Ch. June 30, 2021), which was highlighted on these pages, for the following block quote that elaborates on the fiduciary duties of a manager of a Delaware LLC:

“In the limited liability context, as in the corporate context, the duty of loyalty mandates that the best interests of the company and its stakeholders take precedence over any interest possessed by the manager and not shared by the stakeholders generally. A manager is not permitted to use their position of trust and confidence to further their private interest. Nor can fiduciaries intentionally act with a purpose other than that of advancing the best interests of the corporation. Specifically, and very pertinently for this case, such fiduciary duties include the duty not to cause the corporation to effect a transaction that would benefit the fiduciary at the expense of the minority stockholders.”

Slip op. at 74 (citing Largo Legacy Group LLC).

Also notable is footnote 315 for its explanation about why the breach of contract claims in this case did not overlap the fiduciary duty claims, and why both were permitted to be pursued through trial in this matter. See, e.g., Largo Legacy Group decision: In addition to the statement of fiduciary duty quoted above, the Largo Legacy case also clarified when tandem claims of both breach of contract an breach of fiduciary duty can proceed at the same time.

Although not covered in this brief blog post, the court also addressed several other important issues for corporate and commercial litigators in Delaware:

● The elements of a claim for fraud or fraud in the inducement.
● Breach of a contract regarding LLC agreement terms.
● Elements of an acquiescence defense.
● Elements of an unclean hands defense.
● Why damages need not be proven with mathematical certainty after a breach is established. Slip op. at 103-104.
● Fee shifting principles.