In Gantler v. Stephens, (Del. Supr., Jan. 27, 2009), read opinion here, the Delaware Supreme Court, yesterday, issued a major decision on important matters of Delaware corporate law. Delaware’s High Court for the first time confirmed and clarified that officers of Delaware corporations have the same fiduciary duties as directors of Delaware corporations.
In addition, the Delaware Supreme Court clarified and enunciated Delaware common law on the issue of "shareholder ratification".
In a rare reversal of the Chancery Court, the Supreme Court determined that the breach of fiduciary duty claims in this case should be allowed to proceed, and explained why the board should not enjoy the presumption of the business judgment rule at this stage of the proceedings, based on the pled facts (contrary to the Chancery Court’s dismissal of the case, based on an earlier opinion summarized here.)
The Supreme Court’s own succinct introductory summary to its opinion follows:
The plaintiffs in this breach of fiduciary duty action, who are certain shareholders of First Niles Financial, Inc. (“First Niles” or the “Company”), appeal from the dismissal of their complaint by the Court of Chancery The complaint alleges that the defendants, who are officers and directors of First Niles, violated their fiduciary duties by rejecting a valuable opportunity to sell the Company, deciding instead to reclassify the Company’s shares in order to benefit themselves, and by disseminating a materially misleading proxy statement to induce shareholder approval. We conclude that the complaint pleads sufficient facts to overcome the business judgment presumption, and to state substantive fiduciary duty and disclosure claims. We therefore reverse the Court of Chancery’s judgment of dismissal and remand the case for further proceedings consistent with this Opinion.
The distilled essence of the factual genesis of this case is the decision of the Board of First Niles Financial to sell itself, but thereafter not taking seriously three offers that it received, and instead appearing to favor a privatization or a reclassification plan. The three basic claims in the complaint were that the board members breached their fiduciary duties to the First Niles shareholders by rejecting an offer from a potential buyer and abandoning the sale of the company. Secondly, the claim was that the defendant directors breached their fiduciary duty of disclosure by disseminating a materially false and misleading proxy regarding the reclassification. Third, the amended complaint alleges that it was a breach of fiduciary duty to implement the reclassification plan.
The Chancery Court dismissed the amended complaint, ruling that it failed to allege facts that were sufficient to overcome the presumption of the business judgment rule and for failing to establish that the proxy was materially false and misleading, as well as based on the argument that the shareholders “ratified “ the decision of the board to reclassify the shares.
The Supreme Court reviewed the trial court’s grant of the motion to dismiss on a “de novo basis” to determine whether “the trial judge erred as a matter of law in formulating or applying legal precepts.”
Although Count I of the complaint alleged that the directors breached their duties of loyalty and care by abandoning the sale of the bank in order to retain the benefits of incumbency, the trial court concluded that the Unocal standard did not apply because the complaint did not allege any “defensive” action by the board. The trial court also determined that the entire fairness review was not applicable because the board did not interpose itself between the shareholders and a potential acquirer by means of defensive measures, and thus the trial court applied the business judgment standard and concluded that the allegations in the complaint failed to rebut the presumption of business judgment.
The Supreme Court upheld the Chancery Court’s refusal to apply the Unocal standard because the essence of the transaction at issue was not defensive and the initial count in the complaint was based on disloyalty as opposed to defensive conduct. Nor does Count I allege any hostile takeover attempt or similar threatened external action from which it could be inferred that the defendants acted defensively, despite the allegation that they improperly delayed or sabotaged the due diligence process.
The Business Judgment Rule
Next, the Supreme Court addressed whether the trial court appropriately found that the plaintiff did not satisfy the burden of pleading facts sufficient to rebut the presumption of the business judgment rule that “in making a business decision the directors of a corporation acted on an informed basis, in good faith and in the honest belief that the action taken was in the best interest of the company.” (citing Aronson v. Lewis, 473 A.2d 805, 812 (Del. 1984)).
Delaware’s High Court recognized that a board is generally entitled to the presumption of the business judgment rule in declining a merger opportunity because implicit in the statutory authority of the board to propose a merger, is also the power to decline a merger.
In order to determine whether the board merits the business judgment presumption, the court makes a two-part analysis. First, did the board reach its decision in the good faith pursuit a legitimate corporate interest. Second, did the board do so advisedly (see footnotes 29 to 31).
The first prong of the analysis requires that the duty of loyalty be examined. In this case, the plaintiff alleges that the directors had a disqualifying self-interest because they were financially motivated to maintain the status quo and to keep their current positions. The Supreme Court was wary of such an argument which it recognized to be tautological, to some extent, because a board decision to reject a merger proposal could always enable plaintiff to assert that a majority of the directors had an entrenchment motive. For that reason, the court explained that in addition to that argument, other facts that support a disloyal motive must be stated.
The Supreme Court determined that a sufficient showing to establish disloyalty at least at this early procedural stage was demonstrated. The court reasoned that the pled facts were sufficient to establish the disloyalty of at least three of the directors, which suffices to rebut the business judgment presumption because in this case three of the directors constituted a majority. Also, for purposes of Rule 12(b)(6) there was a sufficient “director-specific analysis” to demonstrate that a majority of the board was conflicted based on specific alleged conduct from which a duty of loyalty violation can reasonably be inferred. The court recites in detail in its opinion specific facts about each individual director and why such allegations support a conflict.
Officers Share Same Fiduciary Duties as Directors
Importantly, in this decision, the Delaware Supreme Court for the first time explicitly holds, what has been implicitly stated previously and has been also acknowledged by the Delaware Chancery Court, and that is: “officers of Delaware corporations, like directors, owe fiduciary duties of care and loyalty, and the fiduciary duties of officers are the same of directors.” (See footnote 36, but also note footnote 37 which acknowledges that DGCL Section 102(b)(7) does not exculpate officers from liability for breaches of their duty of care in the current statutory provision.)
On the issue of whether a delay in the due diligence process was a breach of the fiduciary duty of the directors, the Supreme Court disagreed with the trial court. The Supreme Court explained that on a motion to dismiss, the trial court is “not free to disregard that reasonable inference, or to discount it by weighing it against other, perhaps contrary inferences that might also be drawn,” making reference to the decision of the trial court that a delay of a couple of weeks could not be the basis for a breach of fiduciary duties.
Disclosure Violations Held Material
In addition, the Supreme Court determined that the proxy disclosures concerning the deliberations of the board about the offer that was rejected, were materially misleading. The court reviewed the materiality standard and reached a different conclusion than the trial court, thus allowing that claim to proceed.
Duty of Loyalty Claim Allowed to Proceed
Lastly, the Supreme Court also reversed the trial court’s decision on Count III of the complaint which alleged that the directors breached their duty of loyalty by recommending the reclassification proposal to shareholders for purely self-interested reasons (that is, to enlarge their ability to engage in stock buy-backs and to trigger appraisal rights). The Supreme Court reasoned that the trial court’s ruling on “shareholder ratification grounds” was in error for two reasons. First, because a shareholder vote was required to amend the certificate of incorporation, without the approving vote it could not operate to “ratify” the challenged conduct of the interested directors. Second, the claim that the reclassification proxy contained a material misrepresentation, eliminates the essential prerequisite for applying the ratification doctrine, namely, that the shareholder vote was fully informed.
Common Law Shareholder Ratification Doctrine Clarified and Enunciated
The Supreme Court recognized that the current scope and effect of the common law doctrine of “shareholder ratification” in Delaware is unclear. Thus, in order to
“restore coherence and clarity to this area of our law, we hold that the scope of the shareholder ratification doctrine must be limited to its so-called ‘classic’ form; that is, to circumstances where a fully informed shareholder vote approves director action that does not legally require shareholder approval in order to become legally effective. Moreover the only director action or conduct that can be ratified is that which the shareholders are specifically asked to approve. With one exception, the “cleansing” effect of such a ratifying shareholder vote is to subject the challenged director action to business judgment review, as opposed to “extinguishing” the claim altogether (i.e., obviating all judicial review of the challenged action.) "
(emphasis in italics and underlining are mine)(See footnotes 52 through 54 for supporting citations).
Moreover, yet another major judicial statement in this opinion is contained in footnote 54. Referring to the last sentence in the foregoing block quote, footnote 54 states that “to the extent that Smith v. Van Gorkom holds otherwise, it is overruled.” (488 A.2d 858, 889-90 (Del. 1985)). Of special note in footnote 54 also is the clarification that the references in this opinion only refer to the common law doctrine of shareholder ratification and are not intended to alter the jurisprudence governing the approving vote of disinterested shareholders pursuant to Section 144 of the Delaware General Corporation Law.
Much more can be written, and much more will be written, about this very momentous decision that announces very substantial clarifying statements of Delaware corporate law. This summary is already longer than most blog posts but I look forward to linking to additional scholarly commentary by others.
UPDATE: Prof. Usha Rodrigues on The Conglomerate blog comments on the case here and she links to her own article on the topic as well as to seminal writings on the issue by Prof. Lyman Johnson here. The Unincorporated Business Law Prof Blog comments on the case here. Also, Prof. Lawrence Cunningham on the Concurring Opinions blog comments, with some aggregation of other remarks about the case, here.
UPDATE II: Here is a post about the opinion on DealLawyers Blog which agrees it is an important decision.