A recent Delaware Court of Chancery decision addressed how the court will review claims against an independent and disinterested board for breach of the duty of loyalty in connection with a merger transaction. The opinion styled Kahn v. Stern, C.A. No. 12498-VCG (Del. Ch. Aug. 28, 2017), involved allegations made unsuccessfully, that the board of directors breached their duties as a result of side deals that allegedly were made in connection with a merger that personally benefited the directors in an inappropriate manner. Allegations were also made unsuccessfully that insufficient information was provided to stockholders before a majority approved the merger by written consent.
The detailed facts are essential for a complete understanding of the decision by the court, however, for purposes of this short blog post a focus on the court’s analysis and its application of the legal principles involved has the most widespread usefulness.
A critical determination was the court’s finding that three of the five board members were considered independent and disinterested. That determination by the court impacted the standard of review that the court applied.
The court began its legal analysis with a review of the requirements that a complaint must satisfy in order to prevail on a motion to dismiss, which was the procedural posture in which the decision in this case was made. In particular, where, as here, there was no controlling or majority stockholder, and the court found that three out of the five directors were considered independent, the complaint was required to include “sufficient facts to show that a majority of the board of directors breached the fiduciary duty of loyalty.”
That is, because the court found that a majority of the board was not dominated or controlled by an interested party, the board enjoyed the presumptions of the business judgment rule. Generally, under the business judgment rule, the court will not second-guess well-informed, independent and disinterested board decisions. Notably, there was no enhanced scrutiny applicable because no Revlon claim was made that the board did not attempt to obtain the highest possible price for the company.
There was no issue whether two of the five directors were considered independent and disinterested. The determining factor was whether the third director, Joseph Daly, could be so described.
In the court’s analysis to determine whether Daly was “disinterested,” which would have resulted in a majority of the board not being disinterested, the court observed that the sole allegation regarding Daly was that he had a large, illiquid block of shares, and that he aligned himself with another stockholder that was supporting the sale of the company, and that Daly was excluded from the special committee. Daly owned approximately 19.1% of the company, making him the largest single stockholder. There is no allegation that Daly received different or unique consideration. Nor does the complaint allege that he faced a liquidity crisis or an urgent need to sell his stock. The complaint failed to plead a disabling interest of Daly because his incentives were the same as that of other stockholders: to maximize the value of his interests.
The next issue was whether Daly was an independent director. The court explained that to plead a lack of independence, a plaintiff must plead facts that, if true, overcome the presumption of a director’s faithfulness to his fiduciary duties. There was no detail in the complaint to support the conclusion that Daly was unable to “objectively make a business decision” concerning the merger.
The court reasoned that in the face of a majority of disinterested and independent board members, and an exculpatory charter provision, in order to survive a motion to dismiss and pursue a post-closing damages claim for breach of fiduciary duty, the plaintiff was required to plead facts making it “reasonably conceivable that a majority of a board acted in bad faith.”
Bad faith will be found if a “fiduciary intentionally fails to act in the face of a known duty to act, demonstrating a conscious disregard for his duties.” Bad faith may also be found when “the decision under attack is so far beyond the bounds of reasonable judgment that it seems essentially inexplicable on any ground other than bad faith.”
The allegations that the board members approved the merger without knowledge of the side deals and that there were omissions and misstatements in the information provided to stockholders, was insufficient to establish bad faith. The court reasoned that the complaint did not plead facts that created a reasonable inference of bad faith because the amount of the reduction in the merger price allegedly based on the side deals was never described in detail; more importantly, details to negate the good faith of the independent directors who approved the merger in light of the side deals was absent from the complaint.
The court found that there were insufficient facts in the complaint to support the allegations that the actions of the board members were made without the best interest of the corporation in mind, and there were also insufficient facts to support the argument that it was “reasonably conceivable that the board took action inexplicable on grounds other than bad faith.”
Regarding the disclosure omissions and misstatements, the court observed that if the issues were presented in a pre-closing request for injunctive relief, the court would have employed enhanced scrutiny to review the disclosure allegations, not to determine damages. In a pre-closing procedural context, unlike in the current procedural posture, if appropriate, the court would afford equitable relief in aid of a stockholder pursuing statutory voting or appraisal rights.
By contrast, in this post-closing request for damages, the focus is on whether the directors of the acquired entity are conceivably liable for damages based on a non-exculpated breach of fiduciary duty due to the alleged failure to make material disclosures. Specifically, that would require the plaintiff to point to facts in the complaint to support an inference that the board acted in bad faith in issuing the disclosures, implicating the duty of loyalty – – as opposed to a mere erroneous judgment in the failure to make a disclosure which would implicate the duty of care which in this instance is exculpated by a provision in the charter.
The court explained that in a post-closing claim for damages, information deficiencies that might be found material in support of a claim for injunctive relief pre-closing, may be insufficient to support a claim for damages where, as here, nothing in the record created an inference that the directors deliberately withhold information or disregarded a manifest duty.