Chancery Describes Penalties Available for Discovery Violations

The Court of Chancery recently explained the public policy reasons for enforcing discovery rules and scheduling deadlines, as well as explaining the types of penalties available for failure to comply with discovery obligations or deadlines.

The key takeaways from the decision in Terramar Retail Centers, LLC v. Marion #2-Seaport Trust U/A/D June 21, 2002, C.A. No. 12875-VCL (Del. Ch. Dec. 4, 2018), include the following:

  • The court explains the policy reasons for the need to enforce the rules of discovery and scheduling deadlines. See pages 19 to 20.
  • The court describes the types of penalties that are available for the court to impose for a party’s failure to comply with discovery rules or deadlines. See pages 21 to 25. See generally, Rule 37(b)(2).
  • The court explained that Delaware courts generally will strictly adhere to discovery deadlines. See footnote 48.

There are multiple Delaware decisions highlighted on these pages regarding the topic addressed in this decision. See, e.g., here and here.

Benefit Corporations and Delaware Law

We have referred to Delaware legislative developments regarding benefit corporations previously on these pages, but a recent article in Forbes provides helpful background information about the history and genesis of the Delaware statutory provisions regarding this rather new aspect of Delaware corporate law. The article features a prominent Delaware lawyer who is a major player in promoting benefit corporations. In essence, the relatively new statute allows a corporation to be formed in order to have as its legitimate and explicit purpose more than only the maximization of profit for stockholders. The article linked above should be of interest to anyone who wants to know more about this developing topic.

Chancery Upholds Board’s Rejection of Pre-Suit Demand

This synopsis was prepared by Mitchell Mengden, a law student at the Georgetown University Law Center.

A recent Delaware Court of Chancery opinion outlines the applicable standards when challenging a board’s decision to reject a pre-suit demand. In Busch v. Richardson, C.A. No 2017-0868-AGB, (Del. Ch. Nov. 14, 2018), the court upheld a board’s decision to refuse a pre-suit demand that the company pursue claims against its Chairman and CEO as well as others, in connection with a demand to unwind allegedly conflicted transactions. The plaintiff did not adequately demonstrate that a majority of the board was interested or lacked independence such that it would compromise their impartiality, nor did the plaintiff allege particularized facts that raise a reasonable doubt concerning the good faith or the reasonableness of the board’s investigation in connection with rejecting the pre-suit demand.

Brief Background:

A shareholder demanded that the company take action to unwind three transactions that the company did not originally disclose as related-party transactions. Two were a repurchase of the company’s stock from its Chairman and CEO, and one was a repurchase from a charity that the Chairman and CEO controlled. The shareholder involved also claimed that the company misled him with respect to the board’s independence.

In response to the pre-suit demand, the board formed a special committee, which ultimately concluded that there was no basis to initiate action against any officer or director. The shareholder involved subsequently filed this action, claiming breach of fiduciary duty by each of the five directors.

Analysis of the Court:

The court declined to apply the two-part test from Zapata Corp. v. Maldonado, because the approach in that case applies where a derivative suit is brought, demand is excused, and then the company attempts to cleanse conflicts by creating a special litigation committee to determine the course of the derivative litigation–which was not the case here. See footnotes 105-11 and accompanying text.

The court provided the following well-established pre-suit demand principles:

  • Demand can be excused where: (1) an adjudication is made that demand is excused; or (2) no motion to dismiss is filed under Rule 23.1 in the face of well-plead allegations that a majority of the board is conflicted. See footnote 106.
  • Under Delaware law, there are two different tests for determining whether demand may be excused: the Aronson v. Lewis test and the Rales v. Blasband test. See footnote 112 and accompanying text. The Aronson test generally applies when “a decision of the board of directors is being challenged in the derivative suit[,]” whereas the Rales test generally applies when “where directors are sued derivatively because they have failed to do something.” See footnotes 113-16 and accompanying text.
  • For a complaint to survive a Rule 23.1 motion to dismiss under Rales, it must “plead facts specific to each director, demonstrating that at least half of them could not have exercised disinterested business judgment in responding to a demand.” See footnote 121 and accompanying text.

In this matter, the court applied the demand refusal framework described in Spiegel v. Buntrock, in which the Supreme Court recognized the high hurdle a plaintiff faces when a pre-suit demand is made, because such a demand:  “tacitly concedes the independence of a majority of the board to respond.” In that situation, as our Supreme Court held in Spiegel v. Buntrock, the decision to refuse a plaintiff’s demand is afforded the protection of the business judgment rule. In addition, the court explained, if the board refuses the stockholder’s demand, “the only issues to be examined are the good faith and reasonableness of its investigation.” See footnote 73.

The Court in this matter concluded that: Under the Spiegel framework, a board’s decision to “refuse a plaintiff’s pre-suit demand is afforded the protection of the business judgment rule unless the plaintiff alleges particularized facts that raise a reasonable doubt as to whether the board’s decision to refuse the demand was the product of valid business judgment.” The Court also held that the plaintiff did not do so because he failed to “allege particularized facts that raise a reasonable doubt that (1) the board’s decision to deny the demand was consistent with its duty of care to act on an informed basis, that is, was not grossly negligent; or (2) the board acted in good faith, consistent with its duty of loyalty.” See text accompanying footnotes 75 and 76.

Non-Signatory May Enforce Forum-Selection Clause

A recent Delaware Court of Chancery decision recognized that a non-signatory to an agreement may enforce the provisions of a forum-selection clause under certain conditions. Although this holding is counterintuitive, there are other Delaware decisions which recognize that in some circumstances a non-signatory to an agreement may either enjoy the benefits of that agreement or may enforce certain terms of that agreement. See, e.g., selected cases addressing this topic on this blog over the last 13 years.

In the case of Lexington Services Ltd. v. U.S. Patent No. 8019807 Delegate, LLC, C.A. No. 2018-0137-TMR (Del. Ch. Oct. 26, 2018), two important principles of Delaware law regarding enforceability of forum-selection clauses were explained. This case involved multiple litigations in several jurisdictions, including a foreign country, regarding the disputed transfer of rights in a U.S. patent.  (The photo nearby of the Roman Forum seems appropriate to add color to an overview of a case involving a forum-selection clause.)

The first principle of well-established Delaware law recognized in this decision was the enforceability generally in Delaware of forum-selection clauses.  They are regarded as presumptively valid and should be specifically enforced absent a showing that the enforcement would be unreasonable and unjust for reasons such as fraud. See footnote 28.  Mere inconvenience or additional expense is not the test of unreasonableness. Id.

Next, this decision recognizes that Delaware law allows non-signatories to invoke forum-selection clause provisions in an agreement where they are “closely related to one of the signatories such that a non-party’s enforcement of the clause is foreseeable by virtue of the relationship between the signatory and the parties sought to be bound.” See footnote 43.  Citing well-settled case law, the court added that, for example, officers and directors of an entity subject to a forum-selection clause may invoke its benefits because they were closely involved in the creation of the entity and because they were being sued as a result of acts that directly implicated the negotiation of the agreement that lead to the entity’s creation. See footnote 44.  Likewise in this case, the defendant is an entity created to receive the patent, and the ownership of the patent and assignment to a different entity such as the defendant was foreseen in the applicable agreement.  The party being sued for his actions as a manager of the defendant entity was foreseeable and is closely related to the agreement.

Relying on prior cases, the court noted that it typically grants motions to dismiss under Court of Chancery Rule 12(b)(3) based upon a forum-selection clause where the parties use express language clearly indicating that the forum-selection clause excludes all other courts before which those parties could otherwise properly bring an action. See footnote 31.  In this case, the court imposed a stay due to the possibility that one or more issues would return to Delaware after certain aspects of the case were resolved in the original non-Delaware forum called for in the agreement.

Chancery Increases Bond Posted for Injunction; Explains Document Review Protocols

A recent Delaware Court of Chancery bench ruling provides guidance on two important procedural topics that do not enjoy a robust body of case law to illuminate the nuances that practitioners must be familiar with in connection with certain aspects of Chancery litigation. In the matter styled: In Re Morrow Park Holding LLC, Cons., C.A. No. 2017-0036-TMR (Del. Ch. Oct. 22, 2018) (Transcript), the court provided the applicable standards for addressing two key procedural issues:

(1) How to determine the amount of a bond required by Court of Chancery Rule 65(c) for purposes of satisfying a prerequisite for the issuance of injunctive relief. See pages, 12-13; and 18-19.

(2) How to determine “inadvertence” when a party seeks to claw-back documents that are privileged or otherwise should not have been produced, based on the alleged inadvertent production of those documents, in light of the terms of a confidentiality order, as well as applicable case law. See page 8-10.

In connection with determining whether appropriate procedures were used in order to decide if there was an “inadvertent” production, the court explained “reasonable and customary” protocols for document review to include:

(i) key word searches to generate a pool of responsive documents;

(ii) then using a different set of key word searches to set aside some of those responsive documents as potentially privileged;

(iii) then subjecting those documents to a separate review;

(iv) then reviewing the remaining responsive documents for privilege before production and flagging families of the documents marked as privileged; and

(v) subjecting those to an additional level of review.

The Court described the foregoing as “standard practice.”  That procedure broke down in this situation due to the apparent failure of a vendor and one paralegal to follow those protocols. The court still found inadvertence.

The court also described the factors that supported the court’s conclusion that the production was inadvertent, including those referred to the decision in Jefferson v. Dominion Holdings, which discussed the four factors that the court generally considers to determine whether production of discovery materials was inadvertent. See pages 8-10.

34th Annual F.G. Pileggi Distinguished Lecture in Law

The 34th Annual F.G. Pileggi Distinguished Lecture in Law (named after my father) will be presented by Professor David A. Skeel, Jr., the S. Samuel Arsht Professor of Corporate Law at the University of Pennsylvania Law School. Details about the event on November 2, 2018, are at this link, and as follows:

Hotel du Pont, du Barry Room, 11th and Market Streets, Wilmington, Delaware 19801

Breakfast at 8:00 a.m. and lecture at 8:45 a.m.

One substantive CLE credit available in DE and PA and online registration available at   delawarelaw.widener.edu/pileggi2018

For additional information or for accessibility and special needs requests, contact Carol Perrupato at caperrupato@widener.edu or 302-477-2178.

Highlights of the annual lectures for several prior years have appeared on these pages.

Prior Material Breach No Defense When Contract Benefits Retained

A recent Delaware Court of Chancery opinion explained the risks associated with using prior material breach of a contract as a defense. In the matter of Post Holdings Inc. v. NPE Seller Rep LLC, C.A. No. 2017-0772-AGB (Del. Ch. Oct. 29, 2018), a complaint by the buyer of a business based on alleged fraud and misrepresentation sought indemnification under the stock purchase agreement. This decision, however, addressed counterclaims by the seller that were made for the return of post-closing tax refunds that were payable to the seller pursuant to the stock purchase agreement.

Several important contract interpretation principles in this opinion are noteworthy enough that this decision deserves a place in the toolbox of those involved in corporate and commercial litigation:

  • Although a prior material breach of a contract may relieve a counterparty of performance, that relief from performance only applies if the counterparty claiming a prior material breach does not also retain the benefits of the contract, and/or where, as here, the counterparty is suing to enforce indemnification provisions of the same agreement. See footnote 35 and accompanying text.
  • The foregoing principle illustrates the risk involved with withholding performance based on the claim of prior material breach, because if the court finds that there was no prior material breach, then the lack of performance is not excused.

The court also provided useful rulings on the principles applicable to an attempted “set-off’, as well as rendering a partial final judgment based on Court of Chancery Rule 54(b).

  • The court explained that absent contractual modification, the general rule is that unliquidated claims, for example related to indemnification claims, cannot be applied to set-off (or deduct) the amount of claims made by a counterparty. In this case, even though the original claims in the complaint were much larger than the amount of the judgment granted in the counterclaims, because the indemnification claims in the complaint were unliquidated, the court ruled that the amount claimed in the complaint could not be used as a set-off (or could not be used as a means of “netting out” or deducting the lesser amount of the judgment for the counterclaims from the greater unliquidated amount sought in the complaint.)
  • Under Rule 54(b), when there is a ruling on less than all the claims asserted in a case, the court may make that ruling a final judgment and thus both subject to appeal, and if no appeal then available for execution, under certain circumstances. In this case the court found that Rule 54(b) should be applied to make the ruling on the counterclaims a final judgment for a few reasons, including because the remaining separate claims were unrelated and not likely to be resolved soon (in light of no trial date set for them yet.)

Chancery Finds Breach of Fiduciary Duty But No Damages

In connection with analyzing claims that certain defendants aided and abetted breaches of the directors’ fiduciary duties, a recent Court of Chancery opinion provides an exemplary recitation of important fundamental principles of Delaware corporate law. The court’s decision in the case of In re PLX Technologies Inc. Stockholders Litigation, Cons. C.A. No. 9880-VCL (Del. Ch. Oct. 16, 2018), is a 136-page mini-treatise that explains key tenets of Delaware corporate law in the context of a challenged acquistion.

Brief Background:

This Chancery decision provides a cautionary tale of how a substantial stockholder who successfully waged a proxy battle to put his nominees on the board should not conduct the sale of the company in order to maximize short-term profit for that stockholder.  The major stockholder in this case made himself the Chairman of the Board and then he was appointed as the head of a special committee to consider the sale of the company.  His goal was not to satisfy Revlon duties, but to maximize his profits on his recently acquired stock.

Although no damages were proven, the court criticized how the major stockholder “gamed the system” and aided the breach of fiduciary duties.  Due to a settlement of the claims against most of the original defendants, the only remaining claim addressed in this post-trial decision is a claim of aiding and abetting breach of fiduciary duty.

Key Issues Addressed:

The court’s comprehensive analysis of the law, and thorough application of the facts, provides a textbook explanation of the fiduciary duties of directors and the applicable standards of care and standards of review that the court applies when challenges are made to the sale of a company. The specific issues related to the court’s finding that the directors breached their duty of disclosure when recommending that stockholders tender, both by (i) failing to disclose communications with a potential acquirer and its investment bank (that also was engaged by PLX); and (ii) by depicting recent projections as (falsely) being prepared in the ordinary course of business.

Highlights of Key Fundamental Delaware Corporate Law Principles:

The highlights of this decision provided below in bullet points are based on an assumption that the reader has a basic familiarity with the relevant concepts. The modest goal is to refer to the page or footnote in the Slip Opinion that an interested reader can turn to for a review of the exemplary treatment by the court of important principles.

I)  Existence of Fiduciary Duties:

  • The court provides a classic definition of the fiduciary duty of loyalty and due care owed by corporate directors–as well as the subsidiary element of good faith. See page 73.
  • The opinion recites the elements of a claim for aiding and abetting the breach of a fiduciary duty. See page 72.
  • Regarding the potential basis to question the proper motives for actions taken by those obligated to act in the best interests of others, the following quote from footnote 412 is  worth keeping handy for future reference:

    Greed is not the only human emotion that can pull one from the path of propriety; so might hatred, lust, envy, revenge, . . . shame or pride. Indeed any human emotion may cause a director to place his own interests, preferences or appetites before the welfare of the corporation.   RJR Nabisco, 1989 WL 7036, at *15

  • The court explains the context-specific formulations of fiduciary duty, for example, when a corporation is for sale. See page 74 and footnotes 412 and 413.
  • The court describes another situational manifestation that requires disclosure–which is not a separate duty but rather derives from the duties of care and loyalty–for example, when directors seek action from stockholders. See page 74 and footnotes: 414 to 415.

II)  Breach of Duty:

  • The court distinguishes between the “standard of conduct” and the “standard of review” in connection with the duties of corporate directors. See page 76 and footnotes 416 to 417.
  • The court expounds on the three-tiers of review by the court of director decision-making as follows: (i) the business-judgment rule; (ii) enhanced scrutiny; and (iii) entire fairness. See pages 77 to 80 and footnote 418. The court also instructs on the situations when each of those three standards applies. See footnote 419 and accompanying text.
  • A classic definition of the business judgment rule is amplified at footnotes 420 to 423 and accompanying text.
  • The entire fairness standard is elucidated at footnotes 424 to 426 and accompanying text.
  • The court educates the reader on the intermediate standard of enhanced scrutiny at footnotes 427 through 433 and accompanying text.
  • The court recites well-settled law regarding materiality in the context of disclosure duties. See pages 80 to 81.
  • When a board of directors relies on a financial advisor, the court explains what needs to be in the summary of the financial advisor’s opinion that is provided to stockholders. See pages 91 and 92.
  • When the enhanced scrutiny standard applies, the court provides a description of what directors must demonstrate in order to satisfy their burden of proof. See page 96.
  • The plaintiff has the burden to show, in the context of proving an aiding and abetting claim, that directors acted outside the range of reasonableness. See page 96.
  • The court describes the reasonableness standard in this context. See 97 to 98.
  • The court recounts those instances when a large stockholder who is also a board member has interests that are aligned with all the stockholders, but also observes those instances when the interests of that large stockholder may diverge from those of other stockholders, for example, when that large stockholder either seeks a “quick profit” on a recent purchase of stock–or needs liquidity–as opposed to seeking the highest value in connection with the sale of the company. See page 99 to 103.
  • The court cites to several Delaware Supreme Court cases that explain when weight is given to a deal price, and a market-check for valuation purposes, and which supports the finding in this case of no damages notwithstanding the court’s holding that there was a breach of fiduciary duties. See footnotes 605 to 607 and accompanying text.
  • A useful Appendix created by the court is attached to this opinion, and includes a chart of key Delaware decisions from 1988 through 2014 with a summary of the highlights of those cases in several columns, regarding: (i) the time it took for the deal to close; (ii) amount of the termination fee involved in the case; and (iii) deal protection measures that were described in the court opinions cited in the Appendix provided by the court.

Chancery Imposes Anti-Suit Injunction to Enforce Forum Clause

In connection with a business divorce involving several inter-related entities and two key agreements among the parties that impacted the issues disputed, the Delaware Court of Chancery in Village Green Holding, LLC v. Holtzman, C.A. No. 2018-0631-TMR (Del. Ch. Oct. 5, 2018), enforced the forum selection clause that selected Delaware courts, and imposed an anti-suit injunction to prevent the parties from proceeding in a separate action in Pennsylvania despite the second agreement containing a forum selection clause that selected Pennsylvania courts as a forum for disputes related to some, but not all, of the numerous entities involved in the business break-up. (The nearby photo of the Roman Forum is an appropriate graphic for this post.) Many other decisions interpreting forum clauses have been highlighted on these pages over the last 13 years.

Among the several important legal principles recited by the court in this useful opinion, are the following principles highlighted by bullet points:

  • The court reiterates the familiar prerequisites that must be satisfied in order for a preliminary injunction to be granted. See page 12.
  • On a more nuanced level, the court recites the additional criteria that need to be considered by the court when there is a request for an anti-suit injunction to prevent a party from proceeding in another forum. See page 13.
  • Also discussed by the court were the enhanced or modified prerequisites that must be satisfied for a “mandatory injunction,” which requires a greater showing than one needs for a typical injunction that seeks merely to maintain the status quo.
  • The court recites the basic principle, and cites to the seminal Delaware cases supporting the general rule, that a forum selection clause is enforceable in Delaware. See pages 15 and 16.
  • The court also refers to Section 18-111 of the Delaware LLC Act which gives the Court of Chancery specific jurisdiction to interpret the rights and duties in an LLC operating agreement. See page 18.
  • Exceptions to the enforceability of forum selection clauses, such as fraud, are also discussed. See page 20.
  • The necessary element of irreparable harm required for injunctive relief was described to be established when one is forced to litigate in a forum that is contrary to the selected forum provided for in a valid forum selection clause. See pages 20 and 21.
  • Although a separate agreement between the parties in this case provided for a Pennsylvania forum for only some of the involved entities, the court enjoined the parties from proceeding outside of Delaware regarding claims involving the parties and entities that were subject to the separate agreement that contained a Delaware forum selection clause.

Delaware Supreme Court Clarifies MFW Standard for Application of Business Judgment Review to a Merger

The issue presented to the Delaware Supreme Court in Flood v. Synutra International, Inc., Del. Supr., No. 101, 2018 (Oct. 9, 2018), was whether it was proper for the Court of Chancery to apply the MFW standard by: “(i) allowing for the application of the business judgment rule if the controlling stockholder conditions its bid on both of the key procedural protections at the beginning stages of the process of considering a going private proposal and before any economic negotiations commence; and (ii) requiring the Court of Chancery to apply traditional principles of due care and to hold that no litigable question of due care exists if the complaint fails to allege that an independent special committee acted with gross negligence.” See page 1.

The “MFW standard” was announced by the Delaware Supreme Court in Kahn v. M&F Worldwide Corp., 88 A.3d 635 (Del. 2014), which was highlighted on these pages.  That standard allowed for the deferential business judgment review that be applied to a merger “proposed by controlling stockholder conditioned before the start of negotiations on ‘both the approval of an independent, adequately-empowered Special Committee that fulfils its duty of care; and the uncoerced, informed vote of the majority of the minority stockholders.’” Id. at 644.

The high court concluded, in its majority opinion, that the interpretation of MFW standard based on the foregoing principles was correct, and cited with approval, for support of its conclusion, the high court’s previous affirmance in Swomley v. Schlecht, 128 A.3d 992 (Del. 2015) (Table).

Highlights:

Although this majority decision could be the subject of a lengthy analysis, especially in light of the vigorous dissenting opinion–which is an indication that reasonable people could easily differ on the conclusions in this case–I will provide highlights only in this short post, via bullet points, to allow a quick reference to key parts of the ruling. Those interested may read the whole opinion for a complete understanding of this important decision:

  • One of the issues in the case was whether or not the prerequisites that must be satisfied in order for the MFW standard to apply must be imposed as a condition of the deal at the absolute beginning of the negotiations–or if the imposition of those conditions at the “beginning” of negotiations can be more flexibly determined as a matter of chronology, as opposed to a “bright line test” requiring a specific point in time. See pages 9 to 21.
  • This issue arose because of the description in the Supreme Court’s initial announcement of the MFW decision that the prerequisites that must be a condition of the deal need to be announced “ab initio” which can be translated as “at inception” or “at the beginning.”
  • The court used several descriptions to explain why a more flexible approach should be used for exactly when in the chronology of a deal the conditions must be imposed, by referring to many situations where the word “beginning” does not refer to a specific point in time, such as the “beginning of a book” that extends beyond just the first word in a novel, and may at least include the first few pages of a novel, for example.
  • The court reasoned that a more flexible approach is sensible in terms of focusing on the more meaningful point in a deal when “substantive economic negotiations take place,” as in this case when a second offer letter was sent and no prior economic substantive negotiations had taken place after the first letter, but before the second offer letter was sent.
  • The second issue addressed was whether due care violations were pled in the complaint.
  • This ambiguity was raised by footnote 14 in the original MFW opinion of the Supreme Court, but which was clarified by this case which essentially nullified the dicta in footnote 14 of the original MFW opinion of the court. See pages 23 to 25, where the majority opinion in this case explains why that footnote 14 should not be relied on, and why no due care violation was adequately pled in this case.
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