The Delaware Court of Chancery’s opinion in Fox v. CDx Holdings, Inc., C.A. No. 8031-VCL (Del. Ch. July 28, 2015), addresses a complex set of facts relating to the liability resulting from the intentionally inaccurate valuation of a spin-off in order to avoid tax consequences to the controlling stockholders, which wrongly minimized the value of stock options.
There are a number of eminently quotable insights and observations in this 82-page decision that could easily be the subject of a lengthy synopsis, but for busy readers who would prefer highlights until they can devote more time to reading the whole opinion, I offer a few selected bullet points that should be of interest to corporate and commercial litigators:
- In addition to reciting important concepts of Delaware law, the Court provides insight into what might motivate a person who sold a business, that he founded, for $7 billion dollars over a decade before the facts giving rise to this case, to risk the ignominy described in the opinion in order to avoid paying taxes in connection with the spinoff of a subsidiary of his new company.
- The Court found that: (i) the company breached the applicable agreement that required the board to determine the fair market value of a share of common stock–which impacted the value of options that the plaintiff owned; and (ii) the determination of FMV was not a good faith determination and “resulted from an arbitrary and capricious process.”
- The Court reasoned that Grant Thornton, in essence, copied the valuation report of another major accounting firm, and provided a valuation report in an intentionally low amount that the controlling stockholder requested in order to avoid his tax burden. The Court explained in detail why it reached the conclusion, somewhat startling, that the valuation by one of the country’s leading accounting firms, was done “not in good faith” and was the result of an “arbitrary and capricious” process. Footnote 21 cites to other Delaware opinions that have critiqued misleading and incorrect reports of other iconic firms.
- The board was required to make the determination of FMV but instead the majority stockholder did so. The Court emphasized that “director primacy” is the foundation of the DGCL even if there is a controlling stockholder, and that the board cannot shirk its duties in the face of a controlling stockholder. That is:
Although some controllers and boards may act this way [i.e., letting the controlling stockholder displace the board], Section 141(a) of the Delaware General Corporation Law (the “DGCL”) establishes ―the bedrock statutory principle of director primacy.” Klaassen v. Allegro Dev. Corp., 2013 WL 5967028, at *9 (Del. Ch. Nov. 7, 2013). “[D]irector primacy remains the centerpiece of Delaware law, even when a controlling stockholder is present.” In re CNX Gas Corp. S’holders Litig., 2010 WL 2291842, at *15 (Del. Ch. May 25, 2010).
- The Court explained that an option is not a stock, and holders of an option are not stockholders. The rights of an option holder are based on the document that created the option.
- The following quote is an example of insights the Court provides, with citations to scholarly journals, regarding what motivates people, other than greed, to breach their duties:
I reach these conclusions about Martino and Halbert reluctantly. Other aspects of their testimony were credible, and I am not suggesting that either is inherently bad or malicious. Like all of us, they are multidimensional. Martino appears to have had a respectable career, and he testified to other instances when he has done the right thing. Halbert has achieved great things and, at least through Caris, devoted much of his time and treasure to improving the lives of others. But humans respond to incentives, and powerful incentives can lead humans to cross lines they otherwise would respect. This is particularly true when the transgression can be rationalized, the benefits are immediate and concrete, and the potential costs are distant, conditional, and readily discounted by the chance of detection and the possibility of a successful defense or settlement. (citations omitted)
- For example, the Court quotes from articles that define the psychological explanation of “hindsight bias”, to explain why the wrongdoers in this case may have tried to justify their actions in forcing an artificially low valuation:
“Hindsight bias has been defined in the psychological literature as the tendency for people with outcome knowledge to believe falsely that they would have predicted the reported outcome of an event.” Hal R. Arkes & Cindy A. Schipani, Medical Malpractice v. the Business Judgment Rule: Differences in Hindsight Bias, 73 Or. L. Rev. 587, 591 (1994). “[S]tudies have demonstrated not only that people claim that they would have known it all along, but also that they maintain that they did, in fact, know it all along.” (citations omitted)