The Delaware Court of Chancery addressed a bevy of basic corporate litigation principles in the context of claims challenging the actions of directors, and determining which standards of review apply, and which procedural prerequisites need to be satisfied. In Carr v. New Enterprise Associates, Inc., C.A. No. 2017-0381-AGB (Del. Ch. Mar. 26, 2018), claims for breach of fiduciary duty and related claims challenged a series of transactions, the net result of which was to substantially dilute the ownership of one of the original co-founders of the company, who alleged also that the investor who caused the dilution was able to acquire control of the company for less than fair value, and then the new controller granted an option to a party doing business with the controller to allow the company to be sold at less than the best price–in order to benefit the controller in a separate transaction.
Carr was a co-founder of Advanced Cardiac Therapeutics, Inc. (ACT). ACT’s controlling stockholder is New Enterprise Associates (NEA). The less than optimum price for the sale of ACT pursuant to an option to be exercised in the future, it was alleged, was in exchange for the buyer (or the person with the option to buy) agreeing to invest in another unrelated company that NEA, the controller, had a need for an investment in–and a quid pro quo connected the option to sell and the separate investment.
Highlights of Key Legal Principles Addressed
Among the highlights of the statements of law in this 60-page decision that will be useful for corporate and commercial litigators include the following:
- Most noteworthy about this decision is its consideration of applying the Revlon standard to a set of facts to which Revlon has not previously been applied directly in Delaware. The challenged transaction involved selling an option for a third-party to acquire the company, ACT, as opposed to a decision to sell the corporation outright. The court reasoned that the application of Revlon to an option transaction likely would “turn on the conditionality and other specific features of the option in question.”
- The court discussed several lines of cases applying Revlon which taken together, suggest that the board of directors of a controlled company may have Revlon-like duties when deciding to approve the sale of an option to a third party to purchase the entire company. The court ultimately held that it need not determine whether the board’s approval of the warrant transaction in this matter is subject to enhanced scrutiny because the court concluded that even under the business judgment rule, the plaintiff stated a claim for relief against the directors.
- The court explained the “step-transaction doctrine” which may apply when multiple transactions or a series of agreements are treated as part of a single unitary plan even if not necessarily taking place on the same date. In order for a series of transactions to be treated as a unitary plan, one of three tests must be met. See footnotes 41 and 42 and related text.
Direct v. Derivative Claims
- The court provides a useful explanation of the often difficult distinction between a direct claim and a derivative claim, as well as the rare instance when a claim can be both direct and derivative, but in this case the dilution claims are treated as traditional derivative claims, though the challenge to the warrant transaction is direct. The complaint hedged its bets by pleading all of the claims as direct and derivative in the alternative. See pages 22 and 23.
When Groups Acting In Concert Equal Control Group
- The court explains the standards that will apply to determine whether one or more persons acting together will be treated as a “control group” for purposes of applying the standard of a controlling stockholder. See pages 24 and 25.
Pre-Suit Demand Futility—Aronson and Rales
- Another useful reference is the court’s explanation of when the Aronson test as compared to the Rales test will be used to determine whether pre-suit demand futility has been established. See pages 31 to 33. The court here explained that Aronson applied because at least half of the board that was in place when the alleged breaches occurred was still in place. The court also explained that the Aronson test was met based on the facts of this case so that pre-suit demand futility was adequately established.
- By comparison, the court described the three situations principally where Rales will apply:
“(1) Where a business decision was made by the board of a company, but a majority of the directors making the decision had been replaced; (2) Where the subject of the derivative suit is not a business decision of the board; and (3) Where the decision being challenged was made by the board of a different corporation.”
- The court explained that what is relevant in the end is not whether the board that approved the challenged transaction was or was not interested in that transaction, but whether the present board is or is not disabled from exercising its right and duty to control the corporation.
- Under the Aronson test, the plaintiff sufficiently plead facts in this case that raised a reasonable doubt as to the disinterestedness or independence of the directors in connection with the challenged decisions.
- The court noted that in Rales, the question is whether the board that would be considering the demand but which did not make the business decision being challenged, can satisfy the first and second prongs of Aronson. See footnote 80.
- The court explained why motions to dismiss are rarely granted when the entire fairness test applies in light of the many factual issues that will often be determinative.
The Business Judgment Rule Articulated
- The court provides a useful recitation of the well-known business judgment rule which “provides a presumption that the board made a decision on an informed basis, in good faith and in the honest belief that the action taken was in the best interests of the company.” See footnote 150. Under that standard the plaintiff can survive a motion to dismiss if it has been adequately pled that the directors breached their duty of care or loyalty in coming to their decision. In this case, the court found it was reasonably conceivable that the director defendants breached both of those duties so as to rebut the business judgment rule.
Breach of Duty of Care to Rebut BJR Presumption
- The court explained that the duty of care was breached because the directors did not even engage a financial advisor, for example, and as well the board did not implement any formal process in selling the warrant. In addition, the board did not pursue a transaction with another interested party in an attempt to extract a higher price. Taken together, these factors suggest the board may have been grossly negligent.
Breach of Duty of Loyalty to Rebut BJR Presumption
- Regarding the duty of loyalty, the court found that the presumption of the BJR was rebutted because facts were pled that showed at least half of the six-person board that approved the transaction was not disinterested or independent. See footnotes 153 and 154.
Rights and Duties of Controlling Stockholders
- Controlling stockholders have the right to act in their own interest when acting solely in their capacity as a stockholder and generally have the right sell control without regard to the interests of the minority as long as the transaction is done in good faith. See footnotes 158 through 160 and accompanying text.
- But, the right of a controlling stockholder to do so, must yield when a corporate decision implicates a controller’s duty of loyalty. See footnote 160. For example, a controller may not prioritize a return on its own investment over the maximization of value for all of the company’s stockholders if all of the company stock is being sold. See page 56.
Non-Exculpated Claims against Directors Fail:
- The court dismissed certain non-exculpated claims against certain directors based on the recent Supreme Court decision of In re Cornerstone Therapeutics, Inc., Stockholder Litig., 115 A.3d 1173, 1175-76 (Del. 2015), which made clear that a plaintiff seeking only monetary damages must plead non-exculpated claims against the director who was protected by an exculpatory charter provision to survive a motion to dismiss, regardless of the underlying standard of review for the board’s conduct—be it Revlon, Unocal, the entire fairness standard or the business judgment rule. See footnote 166. The Supreme Court explained the reasoning for this as follows:“When a director is protected by an exculpatory charter provision, a plaintiff can survive a motion to dismiss by that director defendant by pleading facts supporting a rational inference that the director harbored self-interest adverse to the stockholders’ interests, acted to advance the self-interest of an interested party from whom they could not be presumed to act independently, or acted in bad faith.”
- Based on the foregoing, the court dismissed some of the claims against certain of the defendants because there was no argument that they acted in bad faith with respect to the transaction and there were no facts pled that supported a non-exculpated claim.