This 43-page Delaware Court of Chancery decision could serve as a “mini-law review article” that explains the current Delaware law on a wide range of issues important to those involved in corporate derivative litigation, and directors who want to understand the standards by which their conduct will be reviewed by the courts.
The factual and procedural background of this matter is that it is a class and derivative action challenging a stockholder rights offering ("Offering"). The shareholder plaintiff alleges that the directors of the company set the Offering at a deliberately and inadequately low price that would trigger anti-dilution provisions in the agreements governing the stock options and warrants of the controlling shareholder. The shareholder plaintiffs argued that the triggering of the anti-dilution provisions resulted in a benefit being enjoyed by the directors that was not shared by the other shareholders and therefore, was a self-dealing transaction. The Court found, however, that the complaint failed to state a claim because the anti-dilution provisions did not change or challenge the pre-existing contractual rights of the directors which left them in substantially the same position they were in before the rights Offering. Thus, the shareholder did not sufficiently allege disloyal conduct by, for example, showing that the directors acquiesced to the wishes of the controlling shareholder.
This cursory review will simply highlight key aspects of the Court’s opinion so that the interested reader can decide to review the full text of the decision on their own at the above link.
Court’s Summary of Issues in Case and Its Four-Part Holding
The Court described this case as one that “ultimately boils down to an alleged breach of the duty of loyalty and whether or not the defendants obtained a personal benefit through the Offering.” The Court’s reasoning and analysis can be summarized in four parts: (1) The Court cannot draw a reasonable inference from the facts that the Offering’s trigger of the anti-dilution provisions and their effect upon the options worked a material personal gain to the directors at the expense of the public stockholders. Nor did the plaintiff plead sufficient facts to support a claim that the directors acted in bad faith by consciously disregarding their fiduciary duties. (2) Because the court cannot reasonably infer from the facts that the directors received a personal gain by way of the collateral consequences of the Offering or consciously disregarded their duties, their decision to consummate the Offering is protected by the business judgment rule. (3) Of equal importance, the plaintiff has not duly alleged that the controlling shareholder dominated the board as it approved the Offering. (4) The derivative claims were barred because the plaintiff failed to plead that the board of directors were either interested or under the control or domination of an interested party as of the time it asserted the derivative claims.
Court Declines to Convert Motion to Dismiss into Motion for Summary Judgment
Robotti requested that the Court treat the motion to dismiss by the defendants as one for summary judgment because the defendants relied upon documents that were neither integral to, nor incorporated within, the complaint. The Court declined the invitation to treat the motion as one under Rule 56 as opposed to Rule 12(b)(6), which would have given the parties a reasonable opportunity to present all material relevant to a summary judgment motion. The Court observed that matters beyond the complaint may generally not be considered in a ruling on a motion to dismiss except in the following instances: “(1) When such documents are integral to, and incorporated within, the plaintiff’s complaint; or (2) When the documents are not being relied upon for the truth of their contents.” See footnote 49.
Direct v. Derivative Claims
The opinion contains a thorough discussion and analysis of the differences between a direct as compared to a derivative claim. Referring to recent Delaware Supreme Court opinions on the topic, the Court explained that an initial inquiry in determining between a direct and derivative claim requires the following two questions to be addressed: “(1) Who suffered the alleged harm – – the corporation or the shareholders individually; and (2) Who would receive the benefit of the recovery or other remedy?” See footnotes 55 and 56.
The Court discussed the recent cases that have analyzed whether a dilution in the value of corporate stock and overpayment by fiduciaries is direct or derivative. The recent decision in Gentile v. Rossette, 906 A.2d 91 (Del. 2006) was described as involving a controlling shareholder who caused the company to issue the controlling shareholder’s stock in return for debt forgiveness. The Supreme Court in Gentile held that both the corporation and the shareholders were harmed by the overpayment and due to the dual nature of the harm, the claims in that class were both derivative and direct.
Analysis of Bad Faith and Breach of Duty of Loyalty Claims
The Court described a methodology for analyzing allegations of bad faith within the context of a duty of loyalty claim as being recently clarified by the Delaware Supreme Court in Lyondell Chemical Co. v. Ryan, 970 A.2d 235 (Del. 2009). The Court of Chancery explained as follows:
“Mere gross negligence, which includes the failure to inform oneself of available material facts, cannot constitute bad faith. Bad faith, and thus a breach of the duty of loyalty, can arise only when a fiduciary consciously disregards his or her responsibilities. The Court in Lyondell imposed a high standard on any plaintiff advancing such a claim, and recognized a “vast difference between an inadequate or flawed effort to carry our fiduciary duties and a conscious disregard of those duties.” It concluded that fiduciaries in this context breached their duty of loyalty only if they “knowingly and completely fail to undertake their responsibilities.”
In this case, the Court found that Robotti never claimed that the defendants “knowingly and completely” failed to undertake their responsibilities, nor may any such inference be drawn from the complaint.
Business Judgment Rule Applies
This opinion provides a robust discussion of the business judgment rule, its applicability, and the pleading requirements under Rule 23.1.
Notably, this is the first Delaware decision that cites to the current version of the highly regarded four volume treatise on the business judgment rule recently published by Stephen A Radin and which is cited at footnote 89 by the Court as follows: 1 Stephen A. Radin, et al., The Business Judgment Rule: Fiduciary Duties for Corporate Directors 110 (6th ed. 2009).
Referring to the Radin treatise, the Court defines the business judgment rule as follows:
“The business judgment rule, as a general matter, protects directors from liability for their decisions so long as there exists a ‘business decision, disinterestedness and independence, due care, good faith and no abuse of discretion and a challenged decision does not constitute fraud, illegality, ultra vires conduct or waste.’ There is a presumption that directors have acted in accordance with each of these elements, and this presumption cannot be overcome unless the complaint pleads specific facts demonstrating otherwise. Put another way, under the business judgment rule, the Court will not invalidate a board’s decision or question its reasonableness, so long as its decision can be attributed to a rational business purpose.” See footnote 91.
The Court found that Robotti had been unable to allege that defendants were interested in the transaction and it also failed to allege bad faith or conscious disregard of fiduciary duty. Moreover, although Robotti may have plead a failure to act with due care and on an informed basis regarding the transaction, such a conclusion would be unhelpful in light of the provision in the charter pursuant to Section 102(b)(7) which would preclude a claim for damages on that ground.
The Court also conducted an analysis under Rule 23.1 and found that the derivative claims did not satisfy that rule. Footnote 95 and 96 made it clear that the applicable time period to determine whether the pre-suit demand requirement was futile was when the first derivative claim was presented–which was in the second amended complaint. The composition of the Board at that time when the first derivative claim was filed made the Rales v. Blasband case applicable. See 634 A.2d 927, 933-34 (Del. 1993). Under Rales, the Court explained that the relevant inquiry is only whether the board can exercise its independent and disinterested judgment in responding to a demand, where, as here, the majority of the directors responsible for that decision have since been replaced.
Definitions to Determine "Interested" or "Independent" Directors
The Court provides a helpful discussion and definition of the term “interested” for purposes of pre-suit demand upon the board. Likewise for pre-suit demand purposes, the Court provides a useful definition to determine whether a director is "independent" for purposes of a pre-suit demand analysis. See footnote 98: “The mere fact that a director receives some benefit that was not shared generally by all shareholders is insufficient; the benefit must be material.”
For purposes of demand excusal analysis, rather, the plaintiff must show that the alleged benefit was “significant enough in the context of the director’s economic circumstances, as to have made it improbable that the director could perform her fiduciary duties to the . . . shareholders without being influenced by her overriding personal interest.” See footnote 99.
Regarding the independence of a director, the Court emphasized the contextual aspect of the inquiry, which requires a Court to ask “whether the directors are so ‘beholden’ to an interested director or interested controlling shareholder, that ‘their discretion would be sterilized.’ Motivations such as friendship may influence the inquiry, but in order for friendship alone to neutralize the independence of a director, the ‘relationship must be of a bias-producing nature.’” See footnote 101.
The Delaware Supreme Court has required that a complaint identify a relationship between a disinterested director and the interested director or controlling shareholder “that is so close that one could infer that the ‘non-interested director would be more willing to risk his or her reputation than risk the relationship with the interested director.’” See footnote 103.
The Court analyzed the factual situation as it related to each board member at the time the derivative claim was made in the second amended complaint, and found that the complaint did not adequately justify excusal of a pre-suit demand.
Thus, because the Court found that a majority of the board at the time of the derivative claim was both independent and disinterested, Robotti did not sufficiently plead demand futility and to that extent his derivative claims were dismissed. In addition, the claim for self-dealing by interested fiduciaries failed as a matter of law and the facts did not support an inference that the directors consciously disregarded their fiduciary duties or entirely abdicated their responsibilities. Therefore, the complaint was dismissed.