In London v. Tyrrell et al., C.A. No. 3321-CC (March 11, 2010), read opinion here, the Court of Chancery denied a special litigation committee’s (“SLC”) motion to dismiss a shareholder’s lawsuit under Zapata Corp. v. Maldonado, 430 A.2d 779 (Del. 1981) because there were material questions of fact regarding: (1) the SLC’s independence, (2) the good faith of its investigation, and (3) the reasonableness of the grounds upon which the SLC recommended dismissal of the lawsuit. A prior Chancery ruling in this case was highlighted on this blog here.
Kevin Brady, a highly regarded Delaware litigator, prepared this synopsis.
In 1996, plaintiffs Craig London and James Hunt and defendants Patrick Neven and Walter Hupalo, and others founded iGov, a government contracting firm. In 2005, after changing its focus, iGov won a 5-year $300 million contract with the United States Special Operations Command (the “TACLAN” contract). Because of the expenses it incurred in reinventing itself, iGov’s CEO, Neven, hired Michael Tyrrell as a consultant (he later replaced London as CFO of iGov) to help iGov find a lender to supply it with an operating line of credit. Textron Financial surfaced as a possible candidate. Around the same time, defendants decided that it would be advisable to implement an equity incentive plan (the “2007 Plan”) for the benefit of key members of management. Chessiecap Securities, Inc. was retained to value iGov stock for purposes of setting the exercise price of options for the 2007 Plan.
The Valuation Rollercoaster
Throughout 2006, Tyrrell distributed a number of 2007 forecasts which reflected ever-changing EBITDA. On May 4, 2006, Tyrrell sent Textron a fiscal year 2007 forecast reflecting an EBITDA of approximately $3.5 million (the “First Textron Forecast”). On August 15, 2006, Tyrrell sent Textron an updated 2007 forecast showing an EBITDA of roughly $3 million (the “Second Textron Forecast”). On August 23, 2006 Tyrrell sent Chessiecap a 2007 forecast that showed an EBITDA which also had a value of approximately $3 million (the “Original Chessiecap Forecast”). On October 2, 2006, Chessiecap valued iGov equity at $5.5 million, however, Tyrrell told Chessiecap that in his view $5.5 million was “probably on the high side.” On October 18, 2006, Tyrrell sent Chessiecap a revised forecast that eliminated certain revenues and expenses and showed an EBITDA of $1.8 million (the “Revised Chessiecap Forecast”). On October 31, 2006, Chessiecap certified its Final Valuation of the equity of iGov at $4.7 million. Finally, on December 8, 2006, Tyrrell sent Textron another updated 2007 forecast that showed an EBITDA of approximately $3.1 million (the “Third Textron Forecast”).
London and Hunt are Removed as Directors
In January, a split in the board developed over the correct valuation to use. On January 7, 2007, Tyrrell sent an email to iGov management regarding a proposal to purchase London’s shares for $4 per share, but he wanted an updated valuation since he felt that iGov’s “valuation will likely be higher than $4.7 million [the Final Valuation]. . . .” On January 16, 2007, London objected to iGov relying on Chessiecap’s Final Valuation for purposes of the 2007 Plan because he felt the information upon which the Final Valuation was based was stale and inaccurate. On January 17, 2007, Hunt, who also believed the Final Valuation was unreliable, made an offer to buy all of Neven’s stock at $28 per share. Defendants Neven and Hupalo, who owned 42.5% of iGov’s voting stock, teamed up with iGov officer and shareholder Jack Pooley (collectively they owned 50.1% of iGov’s voting stock), and executed written stockholder consents removing London and Hunt from the board and electing Tyrrell to the board.
The 2007 Plan is Adopted
Defendants then engaged Chessiecap to prepare an addendum to its Final Valuation in which, among other things, Chessiecap concluded for the first time that the fair market value per share as of July 31, 2006 was $4.92. Defendants then held a special meeting of the iGov board on January 30, 2007 to consider the 2007 Plan under which the defendants were given 60% of the options granted and the plaintiffs were given no options or shares. The 2007 Plan also provided that the exercise price of the options could not be less than 100% of the fair market value of iGov common stock on the date the options were granted. Defendants unanimously voted as directors to approve the 2007 Plan and simultaneously adopted $4.92 per share as the fair market value of iGov shares on January 30, 2007 based on Chessiecap’s Final Valuation, dated July 31, 2006, and the associated addendum.
Former Directors File Suit
After the 2007 Plan was approved, plaintiffs filed a books and records action under 8 Del. C. § 220. Plaintiffs engaged the McLean Group, a valuation firm, to conduct separate valuations of iGov’s equity as of October 31, 2006 and December 31, 2006 (the “McLean Valuations”). In performing the McLean Valuations, McLean used the Second Textron Forecast rather than the Revised Chessiecap Forecast. The McLean Valuations placed the per share value of iGov equity at $13.32 on October 31, 2006 and $15.45 on December 31, 2006. Around this same time, iGov expanded the size of its board from three members to five, adding Vincent Salvatori and John Vinter. On October 31, 2007, after attempts to resolve the dispute failed, plaintiffs filed their complaint. In February 2008, the complaint was amended in response to defendants’ motion to dismiss. The plaintiffs claimed that the defendants breached their fiduciary duties of care and loyalty in that the defendants materially misrepresented iGov’s business prospects to Chessiecap in order to get a lower valuation for them to acquire iGov stock. The plaintiffs sought, among other things, rescission of the options granted to defendants under the 2007 Plan.
On November 21, 2008, the iGov board formed a two-member SLC comprised of the two new board members (Salvatori and Vinter) to consider whether it was in iGov’s best interest to pursue the derivative claims in plaintiffs’ complaint. The SLC hired legal and financial advisors and conducted an investigation from April 2009 to July 2009. During the investigation, the SLC’s financial advisor (“SRR”) performed valuations of iGov as of October 31, 2006 and January 30, 2007 without reviewing the work done by Chessiecap and McLean. The SLC concluded that October 31, 2006 was an appropriate valuation date because it believed that Chessiecap’s Final Valuation was essentially current as of October 31, 2006, despite being dated July 31, 2006. The SLC determined that January 30, 2007 was an appropriate date because it was the date the challenged 2007 Plan was adopted. SRR also concluded that since iGov was worth $3.90 – $4.15 per share as of October 31, 2006 and $5.24 – $5.39 per share as of January 30, 2007, the $4.92 per share price was “within the range of fair market value” based on the SRR valuations.
SLC Recommends That the Lawsuit Be Dismissed
On August 5, 2009, the SLC filed a Report concluding that the suit was not in the best interests of the Company and recommending that it be dismissed. The SLC concluded that the defendants acted properly in adopting the 2007 Plan and did not breach their duties of care or loyalty. With regards to the duty of care, the SLC found that the 8 Del. C. § 102(b)(7) provision in iGov’s certificate of incorporation exculpates directors from personal liability not involving intentional misconduct or knowing violations of the law. The SLC concluded that a duty of care claim should not be pursued because any breach of care conduct, if it occurred, would be covered by the § 102(b)(7) provision. As to the duty of loyalty, the SLC concluded that defendants’ approval of the 2007 Plan and actions leading to that approval would satisfy the entire fairness standard because the process employed was fair and the $4.92 price was fair. The SLC also determined that no rescission of the options granted under the 2007 Plan was necessary because $4.92 was in the range of fair market value.
Two-Step Analysis under Zapata
Under the Delaware Supreme Court’s decision in Zapata Corp. v. Maldonado, 430 A.2d 779 (Del. 1981) there is a two-step analysis that must be applied to the SLC’s motion to dismiss. First, the Court must review the independence of SLC members and whether the SLC conducted a good faith investigation of reasonable scope that yielded reasonable bases supporting its conclusions. In the second step, the Court applies its own business judgment to the facts to determine whether the corporation’s best interests would be served by dismissing the suit.
Independence Questioned – “Caesar’s Wife” or “My Cousin Vinter”
The Court noted that an SLC member is not independent if he or she is incapable, for any substantial reason, of making a decision with only the best interests of the corporation in mind. Quoting the Supreme Court’s decision of Beam v. Stewart, 845 A. 2d 1040, 1055 (Del. 2004):
Unlike the demand-excusal context, where the board is presumed to be independent, the SLC has the burden of establishing its own independence by a yardstick that must be “like Caesar’s wife”-“above reproach.” Moreover, unlike the presuit demand context, the SLC analysis contemplates not only a shift in the burden of persuasion but also the availability of discovery into various issues, including independence.
In this instance, it was undisputed that neither Salvatori nor Vinter had a personal stake in the challenged transactions and neither faced any risk of personal liability in this action. However, the Court was troubled by the fact that Vinter was related to Tyrell (Vinter’s wife was Tyrell’s cousin) and Salvatori used to work for Tyrell.
While the Court admitted that it was not possible, at this stage of the proceedings, to say unequivocally that either Vinter’s or Salvatori’s independence was impaired, the burden was on them to show no material question existed about their independence.
The Court determined that they had failed to meet that burden. Moreover, the Court noted that there was evidence to suggest that Vinter and Salvatori may not have conducted their investigation objectively after having considered plaintiffs’ claims. In concluding that the SLC failed to satisfy the independence prong of Zapata, the Court stated that members of an SLC “should be selected with the utmost care to ensure that they can, in both fact and appearance, carry out the extraordinary responsibility placed on them to determine the merits of the suit and the best interests of the corporation, acting as proxy for a disabled board.”
“Scope” of Investigation and “Bases” for Conclusion Questioned
To conduct a good faith investigation of reasonable scope, the Court stated that the SLC had to investigate all theories of recovery asserted in the plaintiffs’ complaint and explore all relevant facts and sources of information that bear on the central allegations in the complaint. If the SLC failed to do that, the result would raise a material question about the reasonableness and good faith of the SLC’s investigation.
Here the SLC concluded that § 102(b)(7) provisions such as iGov’s are routinely upheld by Delaware courts and that such a provision protects defendants from personal liability, in the form of money damages, for gross negligence. However, the Court rejected the SLC’s conclusion stating “I find this to be an unreasonable conclusion because the SLC failed to consider that the requested relief in plaintiffs’ complaint is not limited to money damages; it specifically requests that the 2007 Plan be rescinded. Under Delaware law, exculpatory provisions do not bar duty of care claims ‘in remedial contexts . . ., such as in injunction or rescission cases.’
The SLC also concluded that plaintiffs’ duty of loyalty claims should be dismissed because it believed that the 2007 Plan was entirely fair to iGov — (1) the process defendants’ employed to secure approval of the 2007 Plan, particularly the process employed to develop the exercise price, was entirely fair, and (2) $4.92 was a fair exercise price. The Court disagreed finding that it was not acceptable for Tyrell to provide Chessiecap with the Revised Chessiecap Forecast showing an EBITDA of $1.8 million while simultaneously providing Textron with multiple iterations of EBITDA forecasts. The Court stated that this type of behavior in the current economic environment was particularly troubling:
As is evident from the SLC Report, the SLC concluded that the process of adopting the 2007 Plan was fair primarily because the SLC believes it was perfectly normal for Tyrrell to provide “optimistic” and “art of the possible” forecasts to Textron and use those forecasts internally, while at the same time providing a forecast to its valuation expert that was “substantially lower” but something the Company could “actually achieve,” rather than being “wishful.” To put it mildly, this is an interesting conclusion, especially in light of the current credit environment. One would suspect that lenders would prefer a forecast projecting what management believes is actually achievable as opposed to wishful.
The Court also identified a number of questions which were not adequately investigated by the SLC, including: (i) why did Tyrrell provide Chessiecap with the Original Chessiecap Forecast (showing an EBITDA of roughly $3 million) if he did not believe that the projections in that forecast were actually achievable? and (ii) why did Tyrrell provide Textron with the Third Textron Forecast (showing an EBITDA of 3.1 million) after he provided Chessiecap with the Revised Chessiecap Forecast (showing an EBITDA of $1.8 million)?
As to “Fair Price,” the Court questioned how the SLC could determine that both the Chessiecap Final Valuation and McLean Valuations were “tainted” and as a result, the SLC did not rely on either valuation (or any other valuation) in concluding that $4.92 was a fair price. Since the SLC had no professional valuation upon which to rely, the Court found that a material question of fact existed about whether the SLC had a reasonable basis to conclude that $4.92 was a fair price. Finally, with respect to the second prong of Zapata, since the Court found that the SLC failed the first prong of Zapata, the Court noted that it was unnecessary to continue the analysis because the result would not change.
SUPPLEMENT: Professor Bainbridge refers here to a review of the case by Theodore Mirvis and then the good professor suggests that the Delaware standard applicable in this case could benefit from some tweaking to address the unwieldy nature of the formulation of the standard.