Chancery Applies Entire Fairness Standard to Transaction with Controller

A recent Court of Chancery opinion provides a useful reiteration of the reasons why the entire fairness standard will apply to a transaction between a controller and a controlled corporation. The case of In Re Hansen Medical, Inc. Stockholders Litigation, C.A. No. 12316-VCMR (Del. Ch. June 18, 2018), arose from a squeeze-out merger.  The court addressed claims by a purported class of minority stockholders who alleged that a group that controlled more than 50% of the acquired company, used their control to negotiate a beneficial deal for themselves at the expense of the minority stockholders.

Noteworthy nuggets of Delaware corporate litigation principles applied in this decision include the following:

  • The court discusses the two ways in which a person or a group of persons will be considered “controllers” for purposes of determining the applicable standard of review. See Slip. Op. at pages 15 and 16.
  • The court explained that the entire fairness standard applies to a transaction between a controller and a controlled corporation. See page 15.
  • The court also distinguished several prior decisions, on a factual level, where no control group was found. See footnotes 79 and 80.
  • The court provides the definition and an explanation of the entire fairness standard at page 25.
  • The court explains that in line with the case of Cornerstone Therapeutics, Inc. Shareholder Litigation, a plaintiff must plead a non-exculpated claim for breach of fiduciary duty against an independent director protected by an exculpatory charter provision adopted pursuant to Section 102(b)(7), or that director will be entitled to be dismissed from the suit. See page 26 (citing 115 A.3d 1173, 1179 (Del. 2015)).
  • Notably, the court explained, however, that an exculpatory charter provision does not apply to claims of breaches of the duty of loyalty, claims against officers or claims against controlling stockholders. See footnote 104.
  • The fiduciary duty of disclosure was discussed, and in particular the truism that: “Directors of a Delaware corporation have a fiduciary duty to disclose fully and fairly all material information.” See footnote 109. The court added that when a board chooses to disclose a course of events or discuss a specific subject, it cannot do so in a materially misleading way by only disclosing part of the story and leaving the reader with a distorted impression. Rather, “disclosures must provide a balanced, truthful account of all matters they disclose.” See footnote 111.
  • The court discusses what facts will be considered material and what omissions will be considered material.
  • The court also discusses the prerequisites for satisfying a claim for “aiding and abetting a breach of fiduciary duty.” See pages 31 and 32.

Chancery Awards Interim Fees Based on Fee-Shifting Contract Provision

A recent letter ruling of the Delaware Court of Chancery awarded interim fees based on a fee-shifting contract provision, prior to the final conclusion of the case, based on pre-trial rulings on issues covered by the fee-shifting clause. In Sparton Corporation v. O’Neil, C.A. No. 12403-VCMR (Del. Ch. June 18, 2018), the court addressed that fee issue and some related issues in connection with a motion for judgment on the pleadings.

For busy readers who want to know the key issues addressed by the court, and refer to the referenced pages of the decision for more details and descriptions of the factual and legal issues addressed, I will cover several of the more noteworthy parts of the opinion in bullet points:

  • The court describes the heightened requirements for issuing a mandatory injunction, which are more stringent than the prerequisites for a more conventional preliminary injunction. See page 10.
  • The court discusses basis contract interpretation principles at pages 5 and 6.
  • The court discusses the standard for a motion for judgment on the pleadings, pursuant to Rule 12(c), at page 4.
  • The court determined that it did have equitable jurisdiction to rule on a request for specific performance to order an escrow agent to release escrow funds. See footnote 32. (There is some case law, based on different facts, that reached a different conclusion: that a request for monetary relief, including funds held in escrow, is a request for a legal remedy that is outside the equitable jurisdiction of the court.)
  • The court analyzed the request for interim fees based on a fee-shifting contract provision and explained its rationale for why the claims covered by the contract clause would be the basis for an interim award of fees. See pages 13 to 16.
  • The court also addressed the issue of whether the fees were reasonable and notably, determined that pre-litigation research and analysis was covered by the contractual fee-shifting clause awarding fees to the prevailing party, and that those fees also met the test of reasonableness. See pages 16 to 22. See also footnote 54 for a reference to Delaware’s “pizza theory” of fee challenges.

Court of Chancery Has Power to Issue Bench Warrant for Violation of Court Order

The recent Delaware Court of Chancery opinion in Deutsch v. ZST Digital Networks, Inc., C.A. No. 8014-VCL (Del. Ch. June 14, 2018), addresses the court of equity’s authority to issue arrest warrants to enforce its orders. But because it involves facts that are so unusual, for purposes of a short blog post, the only aspect of the decision that is likely to be of widespread application is the court’s careful and scholarly analysis of why it has the authority to issue bench warrants for the arrest of corporate officers whose company has failed to comply with prior court orders finding the company in contempt.

Although the court has the authority to issue bench warrants for the arrest of the corporate officers for the failure of their company to comply with prior court orders, the court decided that before it would issue bench warrants, it would give the corporate officers one final attempt to comply with prior orders and, if requested, the court would hold an evidentiary hearing. In any event, the corporate officers would be able to purge the sanction of coercive imprisonment at any time by complying with the prior orders of the court.

The background facts and procedural history include a demand for books and records from a Delaware company whose principal place of business is, or was, in China. The company ignored multiple prior orders of the court, including prior contempt findings, based on the failure of the company to comply with prior orders.

SUPPLEMENT:Bloomberg article links to this post and provides a more detailed commentary on this case.

Chancery Describes Fiduciary Duty of Loyalty and Remedies Available for Breach

The Delaware Court of Chancery in a recent opinion reiterated the definition of the fiduciary duty of loyalty and explained the flexibility that it has as a court of equity in fashioning a remedy for the breach of that duty. In CertiSign Holding, Inc. v. Kulikovsky, C.A. No. 12055-JRS (Del. Ch. June 7, 2018), the court addressed several issues in connection with claims and counterclaims involving a complex web of inter-related companies and business relationships.  The court provides a graphic chart which described how the 12 entities involved were inter-related.  Among the claims described in this 83-page opinion were breaches of the fiduciary duty of loyalty by refusing to cooperate to correct corporate records for solely personal reasons, as well as related claims.

For purposes of this short blog post, I will focus on the statements of law that will have the most wide-ranging applicability instead of focusing on the very extensive factual allegations.

Additional background facts are contained in a prior decision in this case pursuant to DGCL Section 205 in which the court entered an order validating the outstanding stock and proffered stock ledger to fix the problem arising out of the issuance of capital stock that was not properly approved. See In Re CertiSign Hldg., Inc., 2015 WL 5136226 (Del. Ch. Aug. 31, 2015).

Part of the allegations for breach of fiduciary duty of loyalty arose out of the defendant director’s refusal to agree to cooperate to correct the defect in the corporate records without the company first agreeing to grant a personal benefit to that defendant director.

Key Statements of Law:

Although well-defined and well-established, it remains helpful to review an articulation of the bedrock fiduciary duty of loyalty owed by directors of Delaware companies. The court described the duty of loyalty as follows:

  • “A public policy, existing through the years . . . demands of a corporate officer or director, peremptorily and inexorably, the most scrupulous observance of the duty, not only affirmatively to protect the interests of the corporation committed to his charge, but also to refrain from doing anything that would work injury to the corporation.” Slip op. at 43. See also footnotes 183 and 184.  (citing cases that found a breach of the duty of loyalty when a controlling stockholder implemented an interested transaction that was designed to protect the personal interests of the directors and was not reasonably or necessarily related to the best interests of the corporation.)

In the instant case, the court explained that the duty of loyalty was breached because the defendant director refused to cooperate with the attempt to correct the corporate records—and that refusal jeopardized the existence and operations of the company solely in order to obtain leverage to advance personal interests.

The court also explained that, as a court of equity, it has flexibility to award damages for breach of the duty of loyalty that allows the relaxation of the usual requirement of a connection between causation and the damages resulting from the breach. See Slip op. at 76 and 77. See also footnotes 274 through 277.  In particular, the court explained that “concerns of equity and deterrence justify loosening normally stringent requirements of causation and damages when a breach of the duty of loyalty is shown.”

The court granted attorneys’ fees incurred by the company to correct defective records that the defendant director refused to cooperate to fix as the remedy for breach of fiduciary duty (as opposed to awarding fees for bad faith litigation, for example, which was not the basis for the award in this case). See footnote 287.

Court Explains When Dual Claims for Breach of Fiduciary Duty and Breach of Contract Can Be Pursued

In a recent Delaware Court of Chancery decision in Edinburgh Holdings, Inc. v. Education Affiliates, Inc., C.A. No. 2017-0500-JRS (Del. Ch. June 6, 2018), the court addressed certain procedural rules that should be of interest to corporate and commercial litigators to the extent that the court explains when certain causes of action may or may not be pursued at the same time in the same case.

Brief Background:

This case involved the sale of an education-related business that provided for future payments contingent upon the acquired business achieving certain revenue targets after closing.  The contingent purchase price was payable in four annual installments.  The litigation arose from the refusal of the buyer to make the final annual payment.

Key Legal Principles Addressed by the Court:

For purposes of this short blog post, it is useful to address three important principles applicable to corporate and commercial litigation that should be of widespread applicability and interest.

  • The court explains those situations in which a breach of contract claim–and a breach of the implied covenant of good faith and fair dealing–may be pursued in the same case. There are situations where such claims would be duplicative, or an implied covenant claim would be preempted by a breach of contract claim for the same actions, but this opinion explains when one may “thread the needle” to pursue both claims at the same time. See Slip op. at 21 and footnotes 82 to 84.
  • Likewise, dual claims of both breach of fiduciary duty and breach of contract in the same case may only be pursued when they do not run afoul of the following prohibition:“Delaware courts will dismiss a breach of fiduciary duty claim where it overlaps completely with a breach of contract claim and arises from the same underlying conduct or nucleus of operative facts as the breach of contract claim. To determine whether there is an independent basis for fiduciary claims arising from the same general events, the Court inquires whether the fiduciary duty claims depend on additional facts as well, are broader in scope, and involve different considerations in terms of potential remedy.” See Slip op. at 38 and footnotes 136 and 137.

Another articulation of well-established law in this decision that is of great practical usefulness for commercial litigators is the truism that the court explained: one cannot “bootstrap” a breach of contract claim into a fraud claim. See Slip op. at 26 and 27 as well as footnotes 100 and 101. In particular, the court explained that:

  • “Delaware law holds that a plaintiff cannot “bootstrap” a claim of breach of contract into a claim of fraud merely by alleging that a contracting party never intended to perform its obligations. In other words, a plaintiff cannot state a claim for fraud simply by adding a term ‘fraudulently induced’ to a complaint or alleging that the defendant never intended to comply with the agreement at issue when the parties entered into it.”
  • Moreover the court observed that “couching an alleged failure to comply with a contract as a failure to disclose an intention to take certain actions arguably inconsistent with that contract is exactly the type of bootstrapping this court will not entertain.”

Recent Delaware LLC Law Scholarship

A recent law review article provides excellent scholarly insights regarding the interface among the equitable powers of the Court of Chancery and the provisions of the Delaware LLC Act and LLC operating agreements. The article by Professor Mohsen Manesh entitled: “Creature of Contract: a Half-Truth About LLCs,” appears in Volume 42 of the Delaware Journal of Corporate Law (that recently arrived in the mail.)  An example of why this article should be read by anyone who litigates issues involving breaches of an LLC agreement and the potential applicability of equitable remedies, is the section beginning at page 453 of the article which includes the heading:  “Judicial Power to Disregard LLC Agreements,” and includes copious citations to case law and other sources.

Chancery Defines Key Principles of Corporate Litigation

A recent decision of the Delaware Court of Chancery provides useful definitions and explanations for well-established principles applicable to corporate litigation. The opinion in Steinberg v. Bearden, C.A. No. 2017-0286-AGB (Del. Ch. May 30, 2018), involves claims that a board of directors and two of its officers breached their fiduciary duties by making or permitting to be made several materially false and misleading statements about the financial condition of the company.

In connection with dismissing the claims, the court reiterates several basic principles and explains definitions of key terms and standards applicable to stockholder derivative suits.  For example:

  • The court explains the different circumstances in which the Aronson test will be used to analyze demand futility as compared with situations when the Rales test will be used. See pages 15 and 16.
  • The court provides a definition of bad faith to be used when a non-exculpated claim for breach of the duty of loyalty is alleged. See page 21.
  • The court provides an always useful definition of  the standards of “interested” and “independent” for purposes of determining if directors are disabled from considering a pre-suit demand. See pages 19 and 20.
  • The court defines the duty of disclosure owed by officers and directors even when no stockholder action is requested. See page 22.

In sum, the court granted a motion to dismiss for failure to establish pre-suit demand futility in connection with allegations of false and misleading statements

New Delaware Corporate Law Scholarship

The current issue of the Delaware Journal of Corporate Law features an article by Professors James D. Cox and Randall S. Thomas entitled: Delaware’s Retreat: Exploring Developing Fissures and Tectonic Shifts in Delaware Corporate Law, 42 Del. J. Corp. L. 323 (2018). The authors carefully review recent Delaware court decisions that have reduced the role of judicial review in contests for corporate control in deference to decisions of independent directors and appropriate shareholder approval. Those involved in Delaware corporate litigation need to add this to their “must reading” list. The article was presented in connection with the 33rd Annual F.G. Pileggi Distinguished Lecture in Law at the Widener University Delaware Law School.

Trial Court Cannot Impose Fees for Frivolous Appeal

Deciding an issue of first impression, the Delaware Court of Chancery recently ruled that even though it imposed fees, after trial, for bad faith litigation as an exception to the American Rule, and that ruling was affirmed by the Delaware Supreme Court, the trial court was without power to impose additional fees, subsequent to the Supreme Court’s decision, for what was alleged to be an appeal pursued in bad faith. In The Marilyn Abrams Living Trust v. Pope Investments LLC, C.A. No. 1289-VCL (Del. Ch. May 29, 2018), the Court of Chancery explained that only the Delaware Supreme Court can impose fees for an appeal pursued in bad faith and that a party seeking such fees needs to file a separate motion pursuant to Supreme Court Rule 20(f).

That appellate procedure should be contrasted with a few cases where the Supreme Court remanded a case to the Chancery Court directing that the trial court consider whether fees should be assessed based on the rulings of the high court–for conduct occurring in the trial court. Also distinguished in the decision were cases involving a “fee-shifting contractual provision” or a statute that allowed for the award of fees, neither of which applied in this matter. This case is an example of the challenge of prevailing on an exception to the American Rule that each party pays for their own fees.

Supreme Court Clarifies Contract Formation and Forum Selection Clause Principles

The Delaware Supreme Court recently clarified for the first time the test to be used in Delaware to determine whether a contract’s terms are sufficiently definite to create an enforceable contract. In Eagle Force Holdings, LLC v. Campbell, No. 399, 2017 (Del. Supr., May 24, 2018), the court addressed whether various documents signed by the parties met the minimum requirements for enforceable agreements, and the court also observed that personal jurisdiction is established when one is a party to an agreement with a forum selection clause.

Basic Background Facts

The facts presented in this decision by Delaware’s high court present a cautionary tale about the problems that arise when parties sign an agreement despite the first page being marked “draft” at the top and having schedules attached that are blank. The key facts include the following:

  • Two people, Kay and Campbell, agreed to form entities in connection with starting a new business that each would own 50% each of, at least initially. Campbell, for his part, was to contribute intellectual property and Kay would provide about $2 million.
  • Kay contributed the money before final and comprehensive documents were in place and before several key issues, including clear ownership to the IP, were resolved.
  • Although the parties initially signed signature pages for their attorneys to hold in escrow until the deal was consummated, the parties later met–without their attorneys–and signed a Contribution Agreement and an LLC Agreement that were revised after the parties had submitted signature pages to their attorneys. The version the parties signed (without their attorneys present) was marked on the first page as a “draft”. At least one of the attorneys for one of the parties was not aware of the signing, and when he returned from vacation, the attorney sent additional proposed edits to the agreements.
  • After signing the agreements marked “draft” with blank schedules, the parties later acknowledged that there were several open issues that were still not yet resolved. Soon the parties took different positions about whether the agreements they signed were binding or not, in light of the open issues, for example.
  • Kay filed a complaint in the Court of Chancery and obtained expedited injunctive relief, including a status quo order.
  • Campbell appeared initially at an evidentiary hearing but then failed to appear for the second day of the hearing, and other allegations of contempt for his failure to comply with the court’s orders were also presented on appeal.
  • Related to the contract formation issues and the contempt allegations, Campbell argued that the court did not have personal jurisdiction over him.

Key Legal Principles in the Court’s Decision

  • Regarding the issue of personal jurisdiction, the court explained that the parties’ agreements both contained a forum selection clause. If a party consents to jurisdiction by contract, such as through a forum selection clause, that is sufficient to impose personal jurisdiction and the normal personal jurisdiction analysis involving the long-arm statute and the Due Process analysis of “minimum contacts” is not necessary. See footnotes 137 and 138.
  • The court recited the three basic requirements for a valid contract: (i) the parties intended that the instrument would bind them, demonstrated at least in part by its inclusion of all material terms; (ii) these terms are sufficiently definite; and (iii) the putative agreement is supported by legal consideration. This formulation subsumes the concept of an offer and acceptance.
  • Delaware law applies an objective test for determining whether the parties intended to be bound–not subjective intent. Citing Professor Williston, the court observed that a signature is the natural indication of assent in the absence of an invalidating cause such as fraud, duress, mutual mistake or unconscionability. See footnote 153.
  • For the first time, the Delaware Supreme Court announced a standard to determine whether the terms of a contract are sufficiently definite, as follows:   “A contract is sufficiently definite and certain to be enforceable if the court can–based upon the agreement’s terms and applying proper rules of construction and principles of equity–ascertain what the parties have agreed to do.”
  • Quoting from the Corbin treatise on contracts, the court noted that: “The courts must take cognizance of the fact that the argument that a particular agreement is too indefinite to constitute a contract frequently is an afterthought excuse for attacking an agreement that failed for reasons other than the indefiniteness.” See footnote 190.
  • There was an ancillary issue of whether the Court of Chancery could impose sanctions for violation of a court order prior to establishing that it had personal jurisdiction over the person who violated the order. The Supreme Court ruled that: “when a Delaware court issues a status quo order pending its adjudication of questions concerning its own jurisdiction, it may punish violations of those orders with contempt and for sanctions, no matter whether it ultimately finds that it lacked jurisdiction.” The court reasoned that this principle was especially applicable in this case because the party involved appeared in person and litigated the merits of the case.