A recent Delaware Court of Chancery decision should be useful to corporate litigators for its practical explanation of the type of transaction that will be considered an “interested” one and subject to the entire fairness standard. In re Riverstone National, Inc. Stockholder Litigation, Consol. C.A. No. 9796-VCG (Del. Ch. July 28, 2016).
The background of this case involves a merger which included a provision that the purchaser waived the right to pursue any claims against the selling directors for usurpation of corporate opportunity, and the value of that asset – – the claim, that the Court referred to as a chose-in-action, was lost and not accounted for as part of the merger consideration. The Defendant Directors, to the extent that they were also stockholders, received an additional benefit not shared by other stockholders: they were relieved of potential liability they faced in connection with the usurpation claim.
The parties spent considerable time and attention in their briefs on the issue of standing, and the argument that standing for derivative claims was lost when the merger extinguished the stock ownership of the plaintiffs. But, the court did not find the standing issue to be important, and instead regarded the allegations as forming a direct claim that still belonged to the plaintiffs after the merger, based on the argument that the directors were “interested” in the merger and that the merger price was unfair.
The essence of the court’s articulation of the issue was that the Director Defendants violated their fiduciary duties in connection with the merger when they failed to obtain consideration for the value of the claims of usurpation of corporate opportunity, and therefore, the value of those claims that were not included, and which were material, made the price of the merger unfair.
The court held that the majority of the Director Defendants were interested in the merger and the plaintiffs alleged sufficient facts – – at the motion to dismiss stage, to show that the merger was unfair, and the entire fairness standard of review applies. The court also determined, in light of that holding, that the issue of standing need not be addressed because the court determined that the plaintiffs stated a direct claim.
Highlights of Important Principles of Law
Many important legal principles are carefully recited in this opinion and although most of these principles are well known to readers of this blog, it remains useful to highlight them as a reminder of fundamental principles of corporate litigation.
The court described the well-known business judgment rule as follows: “Directors are presumed to act in the best interest of the corporation and their independent and disinterested actions in that regard are therefore largely insulated from review.” See footnote 82. There are exceptions to that deferential standard when the business judgment rule is rebutted. For example, the court will apply a higher standard of review – – enhanced scrutiny – – which allows injunctive relief to protect the interest of the stockholders in receiving the best value for their shares. See, e.g., Revlon, Inc. v. MacAndrews & Forbes Holdings, Inc., 506 A.2d 173, 182 (Del. 1986). Another exception to the application of the BJR is when the existence of bad faith or waste has been adequately alleged.
Importantly, the court emphasized that even in the merger context, when the fairness of the merger is challenged, the stockholders must plead facts that, if true, rebut business judgment and demonstrate a non-exculpated breach of duty, otherwise judicial review ends. See footnote 85.
When Entire Fairness Standard Applies
When stockholders plead particularized facts in connection with board action which demonstrates, if true, that the directors acted in a way, for example, such that their loyalty is divided between corporate interest and material self-interest, then the standard of review is entire fairness, and the burden shifts to the directors to demonstrate that the merger developed a fair price from a fair process.
Definition of “Interested” Director
Related to this analysis is whether a majority of the directors were disinterested and independent. The court defined a director who was interested as involving a transaction where a director appears on both sides of the table or expects to derive a personal financial benefit separate from the benefits bestowed to stockholders generally.
Definition of “Independent” Director
The court defined a director that may lack independence as one who “rather than basing a decision on the merits to the corporation,” made a decision relying on “extraneous considerations or influences.” See footnote 88. The allegations of disloyalty in this case were based on the obliteration of a claim against the directors for usurpation of corporate opportunity which resulted from the merger in which the buyer agreed to waive that claim.
Considerations for Determining When a Claim Against Directors that was Extinguished by a Merger Will Be Permitted to Proceed
(1) The existence of a “chose-in-action” against the directors; (2) Which is brought as a claim that would have survived a motion to dismiss; (3) That the directors at the time of the negotiating and recommending the merger were aware of the potential action; (4) The potential for liability was material to the directors; (5) The directors obtained and recommended an agreement that extinguished the claim directly by contract; (6) The pleading is made with respect to a majority of the directors; and, (7) The complaint is sufficient to rebut the business judgment rule.
Usurpation of Corporate Opportunity
In connection with analyzing these factors, the court provides a definition for usurpation of corporate opportunities. See footnote 91. The court provided a thorough application of the elements of such a claim to the specific facts of this case. In addition to analyzing the elements of a claim for usurpation of opportunity, the court also applied the above listed factors that will be considered in order to allow a claim extinguished by merger to proceed.
The court found that the claim that could have been made against the directors prior to the merger was a viable one that presented the potential for personal liability that was material. The Defendant Directors approved the merger which precluded prosecution of claims as a matter of contract. The Defendant Directors secured this benefit that was not shared by other stockholders. In light of this self-interest, their duty of loyalty is implicated, and they no longer enjoy the presumption of the BJR.
Shifting of Burden Pursuant to Entire Fairness Standard
The court explained that once the plaintiff rebuts the BJR, the burden shifts to the defendant to establish that the merger was the product of both fair dealing and fair price. Even though the application of the entire fairness standard would normally preclude a dismissal of a complaint under Rule 12(b)(6), even in a self-interested transaction in order to state a claim a shareholder must allege some facts that tend to show that the transaction was not fair. See footnote 138 (citing the 2015 Delaware Supreme Court decision of In re Cornerstone, which stated the important principle that a plaintiff must plead a non-exculpated claim for breach of fiduciary duty against an independent director protected by an exculpatory charter provision, or that director will be entitled to be dismissed from the suit.) This rule applies regardless of the underlying standard of review for the transaction.