In Sample v. Morgan, et al., (Del. Ch., Jan. 23, 2007), 2007 WL 177856, read opinion here, the Chancery Court again described in great detail the risk of liability resulting from a putatively independent committee not acting in a truly and "obviously" independent manner. In a very recent opinion in the Araneta case, (see blog summary here), the Chancery Court chided directors for being mere "stooges" of the majority shareholder. In this case the 2 members of the Compensation Committee were non-employee directors described as being, at best: "unwitting and uninformed accomplices in this pre-conceived plan…" (to allegedly entrench the majority of directors).
This very extensive opinion could easily be the subject of a law review article. In fact, the opinion is in many ways similar to a law review article. There are many gems and many details in the opinion that I cannot elaborate on at this time due to the demands of paying clients, but I want to highlight a few and will hope to come back later to amplify. I predict that this opinion will be quoted often and though I have not seen anything yet, I also predict an explosion of commentary in the blogosphere on this case, especially from the corporate law professors who blog frequently about Delaware corporate cases.
Here are a few tempting highlights that should encourage you to read the whole case (see link above to download entire opinion).
Although the court describes over many pages the extensive facts, here are a few of the key facts in a nutshell: a two-person, non-employee Compensation Committee approved, with little investigation and still less deliberation, an "incentive plan" that had the effect of entrenching and consolidating power in the 3 employee-members of the 5-person board. Although the stockholders approved the plan and a charter amendment approving the issuance of new shares, key disclosures were not made in the proxy statement. For example, the stockholders were not told of a plan by the company’s outside counsel to use the new issuance of shares to give all of them to the 3 employee board members (as opposed to "attracting" new employees as the plan was advertised.)
The court rejected the argument that the board was insulated by stockholder approval of the plan for two reasons.
1) The doctrine of ratification is not a blank check. The authority given by stockholders to directors is broad but is tempered by the requirement that the authority be exercised consistently with equitable principles of fiduciary duty. Footnote 54 has a few "money quotes". The court cites to law review articles and Delaware cases for this important principle of broad application:
Every corporate action must be twice-tested: First, by the technical rules having to do with the existence and the proper exercise of power; second, by equitable rules applicable to fiduciaries.
2) The second reason that the directors’ argument of ratification failed is due their inability to demonstrate that they disclosed all material facts to the stockholders in connection with their efforts to obtain stockholder approval for their actions. In order to gain entry into the safe harbor of ratification, one must meet the burden of demonstrating full and fair disclosure. The court discusses the requirements of materiality and why they were not met in this case. Among the important facts not disclosed to shareholders was the memo by the company’s outside counsel that contemplated all the shares going to the 3 employee-directors. Thus, who was the plan designed to attract?
The court suggested that the proxy summary may have been intentionally misleading. Although the court only mentions it in passing, we know that during discovery, a motion to compel was granted to require the production of the memo by the company’s counsel regarding the incentive plan.
I am certain that arguments of attorney/client privilege were made regarding the memo of the company’s counsel to the inside directors regarding the incentive plan, but obviously those arguments did not prevail.
The court rejected the motion of the directors to stay discovery while the motion to dismiss was pending, and in light of the court describing the motion to dismiss by the directors as "frivolous", it is not surprising that discovery was allowed.
The court refused to accept the argument that simply because the non-employee directors may not have been "beholden" to the majority employee-directors, that the claims against them should be dismissed. This is so for two reasons.
First, if evidence at trial shows that the Compensation Committee knew of the scheme to entrench the other directors, questions about their duty of loyalty are raised.
Second, if the Compensation Committee did not inform themselves enough to find out about the scheme, then issues arise regarding whether they satisfied their duty of care.
Moreover (and this is striking and stark from my perspective) the court suggested the possibility of fraud by the company’s outside counsel (who was the only advisor to the committee) if he did not disclose the material facts of the plan to the committee. The other directors who were the recipients of the outside counsel’s memo (regarding entrenchment) may also implicitly, according to the court, be involved in the same fraud on the committee. [Yes, that is strong stuff.]
Thus, the court could not give business judgment rule protection to a committee whose magnanimous actions (to put it charitably) in approving the issuance of shares and payment of taxes on those shares by the company might have been due to a poorly-informed analysis based on conflicted advice from a lawyer subservient to management.
The concept of corporate waste was also discussed and though it is usually subsumed by the duty of loyalty, based on the extreme facts of this case, the court said it could not rule out that waste occurred–even with the very high threshold that must be met for that claim.
Importantly, the court also discussed the concept of "abdication" of a board’s authority and examined what type of contracts a board of directors can sign without abdicating its authority pursuant to Section 141(a) of the DGCL. (See footnotes 75 to 78). The court viewed certain contracts limiting a board’s exercise of power as consistent with exercising its authority. The court reasoned that as it relates to the agreement in this case, there was nothing untoward about a board restricting its future ability to issue shares and that it was perfectly reasonable for a buyer of shares to protect its investment from being diluted.
The court distinguished in footnote 79 several Delaware Supreme Court cases that address agreements that restrict a board’s future actions, such as Quickturn, 721 A.2d 1281 (Del. 1998) and Omnicare, 818 A.2d 914 (Del. 2003), and noting that the last decision "drew two well-reasoned dissents". The court distinguished those cases in several ways. For example, the actions in those cases were in the context of mergers and acquisitions and may have involved both illegal and inequitable matters. Footnote 79 also contains an money quote with wide application:
The Delaware General Corporation Law does not contain provisions that prevent directors from entering into contracts with third-parties for legitimate reasons simply because those contracts necessarily impinge on the directors’ future freedom to act. If the judiciary invented such a per se rule, directors would be rendered unable to manage, because they would not have the requisite authority to cause the corporation to enter into credible commitments with other actors in commerce.
Moreover, the court recognized the principle that: If a contract with a third-party is premised upon a breach of fiduciary duty, the contract may be unenforceable on equitable grounds, and it may be unenforceable as a matter of public policy, but such inquiries are fact-intensive and do not lend themselves to a bright-line test. (See footnote 81)
Procedurally, the court rejected an argument under Chancery Court Rule 19(b) that certain claims could not proceed due to the absence of allegedly indispensable parties in connection with the stock restriction agreement.
Lastly, the court noted that each director’s motivations and actions must be scrutinized individually before any findings of liability can be made. Thus, it was unfortunate that the directors were all represented by the same counsel–and according to the court, the company’s outside counsel whose memo was so inextricably intertwined in the allegations, was apparently the one who was "driving the litigation train" in this case.
UPDATE: Predictably, and fortunately, corporate law professor Gordon Smith has provided scholarly insight and analysis on this case in a blog post here.
Prof. Steve Bainbridge has similarly added to the learned commentary on this case here.