Francis G.X. Pileggi and Kevin F. Brady, over the last five months or so, have highlighted on this blog approximately 100 cases on corporate and commercial law from the Delaware Supreme Court and the Delaware Court of Chancery. Among those cases, we selected the following cases as the most notable during that period of time. The excerpts below from the case summaries also provide links for accessing a more complete synopsis of each case, as well as the full text of each highlighted decision.

Delaware Supreme Court Decisions

Forum Non Conveniens Test Not as Stringent When Delaware Case Not First-Filed

Lisa, S.A. v. Mayorga, No. 410, 2009 (Del. Supr. Apr. 20, 2010), read opinion here.

This Delaware Supreme Court decision affirmed the decision of the Court of Chancery which dismissed the complaint based on forum non conveniens grounds. The prior decision of the Court of Chancery is highlighted here.

Although this case has a lengthy and tortuous history, the sum and substance of the importance of this decision can be briefly summarized as follows:

1) When other pending actions in other jurisdictions are involved, the test to apply to a motion to dismiss on forum non conveniens grounds is the “overwhelming hardship” test. See generally General Foods Corp. v. Cryo-Maid, Inc., 198 A.2d 681, 684 (Del. 1964) ( as supplemented by Parvin v. Kaufmann, 236 A.2d 425, 427 (Del. 1967)) (Listing the six factors that the Court must consider in determining whether to apply the forum non conveniens doctrine).

2) Importantly, however, when a Delaware action is not the “first filed” action, a different standard will apply. The Supreme Court in this case ruled that: “where the Delaware action is not the first filed, the policy that favors strong deference to a Plaintiff’s initial choice of forum requires the Court freely to exercise its discretion in favor of staying or dismissing the Delaware action.” (the “McWane doctrine”) (emphasis in original). See McWane Cast Iron Pipe Corp. v. McDowell-Wellman Engineering Co., 263 A.2d 281, 283 (Del. 1970). As a general rule, litigation should be confined to the forum in which it is first commenced and a Defendant should not be permitted to defeat the Plaintiff’s choice of forum in a pending suit by commencing litigation involving the same cause of action in another jurisdiction of its own choosing.

Notably, at a recent seminar presented by veteran members of the Delaware Bar and a former member of the bench, the view was expressed that this case enunciates what is, in effect, a somewhat new standard–or at least it announces a distinction not previously well-known, and it also indicates a softening of the prior hard-line stance in these types of cases.

In this case, the Court reasoned that because the Delaware action was not the first filed action, the McWane doctrine applied and under that doctrine it is not necessary that the competing cases be exactly the same, but rather, it is sufficient that they be “functionally identical” to the Delaware action and that they were filed in a jurisdictionally competent Court arising out of a “common nucleus of operative facts. See Chadwick v. Metro Corp., 2004 WL 1874652 at *2 (Del. Aug. 12, 2004).

Also, the Court ruled that even if the prior action was no longer pending, and  despite McWane referring to a prior pending action, this Delaware case should still be dismissed, the Court reasoned, because to allow the Delaware action to proceed after the dismissal with prejudice of the prior Florida action would ignore the binding effect of Florida adjudication and also create the possibility of inconsistent and conflicting rulings, which was precisely the outcome that the doctrine of comity espoused by McWane sought to prevent. Because the Court dismissed on forum non conveniens grounds, it did not reach the issue of whether the trial court should have allowed jurisdictional discovery on personal jurisdiction issues. See the complete summary at the following link:

https://www.delawarelitigation.com/2010/05/articles/delaware-supreme-court-updates/forum-non-conveniens-test-not-as-stringent-when-delaware-case-not-firstfiled/

Delaware Supreme Court Addresses Vote Buying and Effort to Reduce the Size of a Board To Remove Sitting Directors

Crown EMAK Partners, LLC v. Kurz, Consol. Nos. 64, 2010 and 85, 2010 (Del. Supr. April 21, 2010), read opinion here. This 55-page Delaware Supreme Court decision affirmed in part and reversed in part the Court of Chancery’s 80-page decision involving a control contest that  featured issues such as “vote buying” and efforts to reduce the size of the board via a bylaw amendment and written consents of shareholders in lieu of a meeting. The trial court’s initial decision was summarized here, and the Chancery decision on an interim application for attorney’s fees issued shortly thereafter was highlighted here.

This important opinion deserves extensive discussion and commentary which time constraints do not allow today, but the bullet points below provide a glimpse of why practitioners and students of  Delaware corporate law need to read the whole opinion. Additional analysis of this opinion should follow soon. In the meantime, the following key points indicate why it will be included in the pantheon of seminal Delaware rulings.

• Although Delaware’s High Court agreed with the Court of Chancery’s decision that there was no improper vote buying, the Supreme Court  (unlike the trial court), determined that the purchase of voting rights and other enumerated rights was a breach of the applicable Restricted Stock Agreement, and therefore, those votes could not be counted. The Court’s treatment of this topic is must reading for those interested in the extent to which Delaware will permit a separation of voting rights from economic rights of stock.

• Both Courts reviewed the requirements for written consents of shareholders in lieu of a meeting pursuant to DGCL Section 228, and they both recognized the requirement that such consents be executed by a stockholder of record–and that DGCL Section 219(c) provides that only stockholders of record who appear on the stock ledger can vote. Where the two Courts diverged, however, was at the point that the Court of Chancery determined that “… if a Cede breakdown is part of the stock ledger for purposes of  Section 220(b), it logically should be part of the stock ledger for purposes of Section 219(c)….”  The Supreme Court determined that due to its finding that the purchased votes were invalidated, it was not necessary to address or decide the issue of whether the Cede breakdown is part of the stock ledger for Section 219 purposes. Thus, it described the trial court’s treatment of that issue as “obiter dictum.”

• The Supreme Court also agreed with the Court of Chancery that the bylaw amendment, that purported to reduce the size of the board as a means of eliminating sitting directors, was in violation of  DGCL Section 109(b). Rather, the correct procedure would have been for the dissidents to follow a three-step process: First, remove the sitting directors by written consent, and then reduce the size of the board, and then elect new directors. See the complete summary at the following link:https://www.delawarelitigation.com/2010/04/articles/delaware-supreme-court-updates/delaware-supreme-court-addresses-vote-buying-and-effort-to-reduce-the-size-of-a-board-to-remove-sitting-directors/

Delaware Supreme Court Clarifies Implied Duty of Good Faith and Fair Dealing; Affirms Primacy of Contract Law

Nemec v. Shrader, Del. Supr., Nos. 305, 2009 and 309, 2009 (Del. Supr. Apr. 6, 2010), read opinion here.

This Delaware Supreme Court opinion features an unusual and vigorous dissent, but is especially noteworthy for its statement of Delaware law on the implied duty of good faith and fair dealing which is imposed on every Delaware contract by both statute and case law. The decision of the Court of Chancery, which was highlighted on this blog here, was affirmed by the majority in this opinion.

Background and Issues

The abbreviated factual setting of this case involves a complaint by two retiring shareholders that the directors of their company exercised the right to redeem their shares shortly before a merger which would have made the value of all shares of the company worth $60 million more. The Chancery Court dismissed claims that the timing of the redemption and the failure to allow the retiring shareholders to participate in an increased value of $60 million was a breach of the implied covenant of good faith and fair dealing. The trial court also dismissed claims of unjust enrichment and a breach of the fiduciary duty by the directors who made the decision. A majority of the Delaware Supreme Court affirmed the dismissal of all of those counts.

ANALYSIS

Implied Duty of Good Faith and Fair Dealing

For the latest iteration of Delaware law on the implied duty of good faith and fair dealing, pages 10 through 16 of the slip opinion in this matter are required reading. This claim is rarely successful and the truisms that the Court recites to support its reasoning include the following: “We will only imply contract terms when the party asserting the implied covenant proves that the other party has acted arbitrarily or unreasonably, thereby frustrating the fruits of the bargain that the asserting party reasonably expected.” (Footnote 13) (emphasis added).

The majority emphasized that it is the intent of the parties at the time of contracting that must be examined. (emphasis in original.) Delaware’s High Court further reasoned that: “Delaware’s implied duty of good faith and fair dealing is not an equitable remedy for rebalancing economic interests after events that could have been anticipated, but were not, that later adversely affected one party to a contract. Rather the covenant is a limited and extraordinary legal remedy.”

Moreover, the Court added that: “A party does not act in bad faith by relying on contract provisions for which that party bargained, where doing so simply limits advantages to another party. We cannot reform a contract because enforcement of the contract as written would raise “moral questions.” See footnotes 26 and 27.

Primacy of Contract Bars Fiduciary Duty Claims

The Court recited the well-settled principle in Delaware that “when a dispute arises from obligations that are expressly addressed by contract, that dispute will be treated as a breach of contract claim. In that specific context, any fiduciary claims arising out of the same facts that underlie the contract obligations would be foreclosed as superfluous.” See footnote 31. This “primacy of contract” principle applied here to bar fiduciary duty claims that arose from a dispute relating to the exercise of a contractual right – – which was the right of the company to redeem the shares of the retiring shareholders. See footnote 31. Moreover, the Court rejected the argument that because the directors benefited from the redemption of the shares that prohibited the participation of the retiring shareholders in the additional $60 million compensation from the merger, because the directors received the same proportionate benefit as all the other non-retiring stockholders. Thus, the Court reasoned that they were making a rational business judgment to exercise a contractual right of the company that benefited all of the current stockholders rather than favoring retired stockholders. See footnotes 22 and 23.

Unjust Enrichment

The Court recited the five elements for a cause of action for unjust enrichment, and determined that the plaintiffs failed to demonstrate each required element. Moreover, the Court emphasized that a claim for unjust enrichment will not prevail when the alleged wrong arises from a relationship governed by contract. See footnotes 34 through 37. See the complete summary at the following link:

https://www.delawarelitigation.com/2010/04/articles/delaware-supreme-court-updates/delaware-supreme-court-clarifies-implied-duty-of-good-faith-and-fair-dealing-affirms-primacy-of-contract-law/

Court of Chancery Cases

Chancery Rejects Request to Enjoin Freeze-Out by Controlling Stockholder

In Re CNX Gas Corp. Shareholders Litigation, C. A. Consol. No. 5377-VCL (Del Ch. May 25, 2010), read 43-page opinion here.

Overview

The Delaware Court of Chancery denied a request for a preliminary injunction in this expedited matter in which the representatives of a putative class of minority stockholders challenged a controlling stockholder freeze-out structured as a first-step tender offer to be followed by a second-step short-form merger.

Applicable Standard of Review

The Court applied the unified standard for reviewing controlling stockholder freeze-outs described in the case of In Re Cox Communications, Inc., Shareholders Litigation, 879 A.2d 604 (Del. Ch. 2005), but explained first as follows at page 14 of the slip opinion:

” As knowledgeable readers understand all too well, Delaware law applies a different standard of review depending on how a controlling stockholder freeze-out is structured.” (citing Kahn v. Lynch Communications Systems Inc., 638 A.2d 1110(Del. 1994)).

The entire fairness standard was applied to the facts of this case for several reasons: (i) the special committee did not recommend the transaction; (ii) the special committee was not provided with the authority to bargain with the controller on an arm’s length basis; and (iii) there was a reasonable question about the effectiveness of the majority-of-the-minority tender condition. The “flip side” of that is the reason the BJR did not apply .

That is, the BJR did not apply because there was no affirmative recommendation by the special committee AND there was no approval by the majority of unaffiliated stockholders.

Reason Why Preliminary Injunction Denied

The Court reasoned that in light of the fairness standard applying, any harm to the putative class could be remedied by a post-closing damages action. Moreover: (i) there was no viable disclosure claim; and (ii) the tender offer was not coercive.
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Chancery Finds Purchase and Use of Corporate Jet to be Protected by the Business Judgment Rule, But Allows Claims to Proceed to Trial in Connection with Personal Benefits Received by Director of Family Owned-Company

Sutherland v. Sutherland, C.A. No. 2399-VCN (Del. Ch. May 3, 2010), read opinion here. This decision is the latest installment in a long-running internecine battle among siblings in a large, closely-held business based in the Pacific Northwest. The eight (8) prior decisions of the Delaware Court of Chancery in this matter have been highlighted on this blog and are available here.

The latest iteration of this family feud involves a motion for partial summary judgment which was granted in part and denied in part. There are many examples in Delaware opinions of lengthy battles among shareholders in large closely-held, family-owned companies that over the span of many years resulted in multiple decisions from the Court of Chancery in the same case. This case deserves a place “on the podium as one of the top three finalists” among such hotly contested disputes.

Procedural History

The first complaint that was filed in this matter was a Section 220 claim filed in 2004. The decision in that case is captioned Sutherland v. Dardanelle Timber Co., 2006 WL 1451531 (Del. Ch. May 16, 2006). The Court allowed documents to be inspected based on credible evidence of possible management entrenchment, as well as possible waste and other breaches of fiduciary duty.

In 2006, the same plaintiff filed a complaint against the same company (and its directors) based on breach of fiduciary duty claims. The company appointed a special litigation committee (“SLC”) which recommended that the company not pursue the derivative claims. However, the Court denied the motion to dismiss based on that SLC report, finding that the investigation by the SLC was lacking in good faith and reasonableness, and that the SLC failed to investigate adequately all of the claims. See Sutherland v. Sutherland, 958 A.2d 235, 242-45 (Del. Ch. 2008).

Claims Addressed

The primary claims addressed in the instant motion for summary judgment include the following: (1) The defendant directors breached their fiduciary duty of loyalty by allowing the company to pay for certain accounting expenses incurred for the benefit of one or more of the directors personally; (2) The purchase and continued use of a company jet was challenged based on the argument that the personal use was a breach of the duty of loyalty, and the decision regarding the jet was allegedly made on an uninformed basis such that it was a breach of the duty of care, and that the purchase and  continuing ownership of the jet was not for a rational business purpose; (3) The third claim was based on the argument that the expenditure by the company of $750,000 in legal fees merely to defend the Section 220 action unsuccessfully, was a waste of corporate assets and was the result of self-dealing and bad faith; (4) The fourth argument was that an amendment to the charter after the litigation commenced to include a Section 102(b)(7) provision to protect the directors with self-dealing; (5) The last primary argument was that an accounting should be provided to establish that the company did not pay for personal expenses of the individual directors.

Analysis

The first claim addressed by the Court is based on the premise that a director may be held liable for receiving some personal benefit that is not shared by other shareholders generally and that was the result of the director’s actions. See footnote 20. However, the Court rejected the argument that simply by appointing the Special Litigation Committee the directors conceded self-dealing. The appointment of an SLC pursuant to Zapata Corp. v. Maldonado, 430 A.2d 779, 786 (Del.1981), may allow for the inference at the initial pleadings stage that a claim for self-dealing was alleged, but it does not concede self-dealing as a substantive matter for purposes of trial or other merits-based decisions by the Court. See footnotes 21 to 26.

In sum, the Court concluded on this particular point that it was a factual issue for purposes of summary judgment, and that the Court could not conclude on the present record that the directors received no material benefit from tax and accounting services that they received personally. Moreover, the Court found that the absence of documentation to support the inference that at least one director received a disproportionate benefit for personal expenses that were paid for him is a problem for the defendants who could not account for the funds paid at this stage of the proceedings.

The second claim concerning the argument that a private jet was not necessary to purchase or to continue to own, was rejected for several reasons. First, it was barred by the statute of limitations, but more importantly, the claims failed to rebut the presumptions of the business judgment rule. The familiar formulation of the business judgment rule was reiterated by the Court. See footnote 71. Moreover, the Court observed that conduct may rebut the presumption upon the showing that the board breached either its fiduciary duty of care, or fiduciary duty of loyalty, but that the decision of the board will be upheld unless it cannot be attributed to any rational business purpose. See footnote 72 and 73.

The duty of due care of directors includes the need to act on an informed basis, although in order to be adequately informed “the board need not know every fact, but is instead responsible only for considering material facts that are reasonably available.” See footnote 76. Moreover, the standard for determining whether the decision of the board was informed is one of gross negligence which is conduct that “constitutes reckless indifference or actions that are without the bounds of reason.” See footnotes 78 and 79. Importantly, the Court emphasized that in connection with analyzing this duty, there is “no prescribed procedure, or a special method that must be followed to satisfy the duty of due care.” See footnotes 80 and 81. See generally DGCL Section 102(b)(7).

The Court also reasoned that the purchase of the aircraft and continued ownership of it clearly had a rational business purpose and was protected by the business judgment rule since it was not otherwise the product of self-dealing.

The argument was also made that because the company incurred approximately $750,000 in legal fees merely to defend the Section 220 action (unsuccessfully), that expense was allegedly an example of the breach of the duty of loyalty because it was merely for self interest that the Section 220 litigation was defended.

The Court observed that it is customary, especially in a closely-held corporation, for the corporation to pay the legal costs to oppose a Section 220 or a Section 225 claim even though there may be some personal benefit to incumbent management by doing so. See footnotes 103. The controlling question, rather, is whether the defendants acted in bad faith by refusing the request for books and records and by contesting the Section 220 action. The Court distinguished the Technicorp and Carlson cases in which the Court had found that there was a bad faith opposition of Section 220 actions that resulted in fee shifting, but those cases were distinguishable from the facts of the instant matter. See footnotes 103 through 106.

The Court also cited to prior Delaware decisions to reject the argument that adopting a Section 102(b)(7) provision (during the litigation) to protect the directors from personal liability was self-dealing. Those arguments had been rejected in prior decisions by the Court of Chancery.

The Court also discussed the Technicorp and Carlson cases in connection with the truism that fiduciaries have a burden to maintain and produce records to explain expenses paid for by the company, but an accounting is only required where improper expenses, or expenses that are unaccounted for, would warrant the Court to require an accounting.

Lastly, the Court acknowledged that because some of the more excessive provisions of the compensation package in the employment agreements of the top executives of the company were changed and made “less generous” as a result of the lawsuit, the Court ruled that some fee shifting would be allowed but that those details would be addressed in a separate proceeding. See the complete summary at the following link:
https://www.delawarelitigation.com/2010/05/articles/chancery-court-updates/chancery-finds-purchase-and-use-of-corporate-jet-to-be-protected-by-the-business-judgment-rule-but-allows-claims-to-proceed-to-trial-in-connection-with-personal-benefits-received-by-director-of-family-ownedcompany/

Chancery Upholds Board Decision to Choose Financing over Bankruptcy

Binks v. DSL.net, Inc., C.A. No. 2823-VCN (Del. Ch. Apr. 29, 2010), read opinion here.

Main Issue Addressed

This 44-page opinion of the Court of Chancery addressed whether the business judgment rule protected the decision of the Board of DSL.net, Inc. on the following issue: Whether to file for bankruptcy or borrow funds from co-defendant MegaPath, Inc.?

Background

The Board chose the deal with MegaPath which involved a loan from MegaPath and the issuance to MegaPath of convertible notes which were exercised to give MegaPath more than 90% of the common stock of DSL, after which it proceeded with a short-form merger and eliminated the minority stockholders. One of those minority stockholders brought this action.

After extensive anlaysis, the Court dismissed the claims for two primary reasons. First, the Plaintiff lost his standing to sue derivatively as a result of the merger. Second, he challenged the actions of the Board of Directors which was comprised of a majority of independent and disinterested directors who had reasonably evaluated the options of the company and solicited responsible advice.

The Business Judgment Rule and Revlon Duties

The Court recited the familiar presumption that directors of corporations enjoy when they act “independently, with due care, in good faith, and in the honest belief that their actions were in the stockholders’ best interests.” This business judgment rule presumption operates, as the Court explained,  to “protect corporate officers and directors and the decisions they make, and our courts will not second-guess these business judgments.” See footnotes 37 to 40.

The Court further explained that Delaware courts apply the protections of the business judgment rule “to decisions made by disinterested and independent directors acting in good faith and with due care. Where business judgment rules are applicable, the board’s decisions will be upheld unless it cannot be attributed to any rational business purpose.” See footnotes 41 and 42.

However, where a transaction constitutes a “change in corporate control,” then Revlon duties “refocus the Board’s traditional fiduciary duties and require it to try in good faith to seek the best value reasonably available to the stockholders.”  Where the duty under Revlon applies, the Court’s ordinarily deferential rational basis review is changed to an objective reasonableness standard of review, both to the process and the result, under which the Court evaluates whether the board has complied with its fundamental fiduciary duties. See footnotes 43 and 44.

It was not clear that Revlon applied to the particular transaction involved in this case although the Court recognized that even if it was a two step transaction, for analytical purposes the relevant events would be “collapsed” into a single transaction for purposes of determining the applicable standard of review. The Court has applied the Revlon standard to a transaction that has the net effect of a change in corporate control, especially where “corporate action plays a necessary part in the formation of a control block where one did not previously exist.” See Equity-Linked Investors, L.P.  v. Adams, 705 A.2d 1040, 1055 (Del. Ch. 1997).

The Court in the instant case was more flexible because of a pro se Plaintiff and acknowledged that by applying the Revlon standard it would arguably allow for a direct claim. However, the Court concluded that even if the Revlon standard applied the obligations of Revlon were met for the following reasons:

1) The board was independent and disinterested regarding the challenged transaction;

2) The board was well-informed by independent advisors of the available alternatives to the company other than the loan from MegaPath; and

3) The board acted in good faith in arranging and committing the company to the challenged transaction, especially in light of the paucity of other options available.

The Court thoroughly examined the basis for its conclusion that the directors were both independent and disinterested, as well as being fully informed. That part of the opinion is factually rich.

The “entire fairness standard” did not apply because MegaPath was not a controlling shareholder at the time of the contested transaction, and that standard would only apply to an actual–not a potential–majority shareholder. See footnote 78.

Decision of the Board Not to File Bankruptcy

The Court relied heavily on the Equity-Linked Investors’ case in its analysis about why the Revlon standard was upheld in connection with the decision of the board to obtain loans as opposed to filing for bankruptcy. The Court rejected the argument from the Plaintiff that bankruptcy was the only other option that would have been preferable because:

“There can be several reasoned ways to try to maximize value. [Thus] the Court cannot find fault so long as the directors chose a reasoned course of action.” See footnote 66. Moreover, the conclusion of the board that the financing transaction was preferable to bankruptcy was within the exercise of its business judgment, and the argument of the Plaintiff to the contrary does not meet the test that the board “utterly failed” to obtain the best price for the shareholders.

In the Equity-Linked Investors case, the preferred shareholders questioned the judgment of the board on the “lip of insolvency” when the board was required to complete a financing transaction rapidly, or else face bankruptcy. The preferred shareholders preferred to have the company liquidated and the assets distributed but the board declined an offer that was perhaps superior to the offer of a third party. Nonetheless, the Court in that case concluded that a board’s obligation to maximize the present value of the firm’s equity was “not obvious” where: (1) The transaction is not a merger or a tender offer with a price for shares; and (2) the transaction or other alternatives were not otherwise easily reduced to a present value calculation. See footnote 69.

Therefore, the Court reasoned that: “The board could have reasonably concluded that pursuing a course that maintained the possibility of further benefits from the company’s assets, including its intellectual property, was arguably superior to the liquidation of the firm.”

The Court acknowledged the difficulty of applying the Revlon test in such circumstances where judgment is required, but reasoned that :

“All that the law may sensibly ask of corporate directors is that they exercise independence, good faith and attentive judgment, both with respect to the quantum of information necessary or appropriate in the circumstances and with respect to the substantive decision to be made.” See footnote 70.

The Court relied on the holding in the Equity-Linked Investors case in which the board  was found to have acted reacted reasonably in pursuit of the “highest achievable present value” of the common stock in concluding in good faith that the “corporation’s interests were best served by a transaction that it thought would maximize potential long-run wealth creation.”

Likewise in the instant case, the Court reasoned that the Plaintiff had failed to plead adequate grounds to infer that the board was anything other than independent, disinterested, and sufficiently well informed ,and therefore his personal opinion that the bankruptcy would have been a superior course of action, cannot sustain a Revlon claim.

The Court also observed the well settled standard for liability of a director for breach of the duty of care as being based on the concept of “gross negligence.” See footnote 56. However, because any duty of care violation would be exculpated by Section 102(b)(7) of DSL’s charter, the Plaintiff was unable to prevail in that aspect of his claim either. See the complete summary at the following link:

https://www.delawarelitigation.com/2010/05/articles/chancery-court-updates/chancery-upholds-board-decision-to-choose-financing-over-bankruptcy/

Chancery Rejects Argument for Jurisdiction Based Only on Ownership of Stock in Delaware Corporation

OneScreen, Inc. v. Hudgens, C.A. No. 4545-VCP (Del. Ch. March 30, 2010), read opinion here.

This Delaware Court of Chancery opinion will be useful to include in the toolbox of litigators who need to know about the latest iteration of Delaware law on the issue of personal jurisdiction, especially as it relates to in rem jurisdictional arguments based on stock ownership in a Delaware corporation.

Issue Addressed

The issue addressed in this opinion by the Court of Chancery was whether personal jurisdiction in Delaware can be based solely on the fact that a defendant owns stock in a Delaware corporation. The short answer is that it is theoretically possible but only as a narrow exception to the general rule which the plaintiff in this case failed to satisfy.

Brief Background

This case involved the effort by OneScreen, Inc. to rescind the transfer of preferred stock from a former CEO based on an argument that it was in violation of Florida criminal statutes and therefore should be voided as against public policy even though OneScreen was not a party to the related stock agreements.

Discussion

Plaintiff argued that it was not seeking jurisdiction over any person but rather was asking the Court to exercise jurisdiction over property–or in rem jurisdiction based on Section 169 of the Delaware General Corporation Law, and Section 365 of Title 10 of the Delaware Code. That argument was unsuccessful.

The defendant successfully moved to dismiss for lack of jurisdiction based on the seminal ruling of the United States Supreme Court in Shaffer v. Heitner and its progeny, standing generally for the position that: “Ownership of stock in a Delaware corporation, on its own, is an insufficient basis on which to hale nonresident defendants into a Delaware Court.” See footnotes 1 and 9. The Court also refers to Court of Chancery Rule 19 for the observation that personal jurisdiction over the parties to the agreement sought to be invalidated would be indispensable, and the inability to obtain personal jurisdiction over them, as opposed to merely in rem jurisdiction, would not allow the Court to proceed in any event.

Due Process Concerns

The narrow exception that would allow the Court to proceed when the only connection to Delaware is ownership of stock in a Delaware corporation would be in those limited circumstances where minimum contacts could be satisfied conceivably in a situation where an action related directly to the “rights or attributes inherent in that stock.” See footnotes 20 through 35 for cases cited.

The Court discussed a series of Delaware cases that interpret the decision of the United States Supreme Court in Shaffer to mean that “ownership of stock that has its statutory situs in Delaware does not, by itself, satisfy the minimum contacts requirement. See footnote 30. Rather, ownership of stock in a Delaware corporation may be a sufficient contact with Delaware to subject the owner of stock to jurisdiction in this Court, “but only in actions relating directly to the legal existence of the stock or its character or attributes.” See footnote 39.

Conclusion and Reasoning

The Court’s conclusion and reasoning can be summarized in the following three parts: First, this action must be dismissed because it does not relate directly to the legal existence, rights, characteristics, or attributes of stock in the Delaware corporation. Second, the complaint does not allege a defect in the corporate process by which the disputed shares were issued nor does it ask the Court to examine those shares in terms of the internal governance of a Delaware corporation. Lastly, the action challenges transactions that only incidentally involve stock in a Delaware corporation. In closing, the Court distinguished this case from corporate plaintiffs in the Hart Holding opinionof this Court in which cancellation of shares was sought as an equitable remedy for fraud. By contrast, OneScreen seeks in this case to invalidate a stock transfer in response to an alleged violation of a Florida criminal statute that does not implicate the corporate process or the validity or attributes of the corporation’s stock. Thus, there is a failure to allege sufficient minimum contacts to support the exercise by the Court of jurisdiction over the defendants. See the complete summary at the following link:

https://www.delawarelitigation.com/2010/04/articles/chancery-court-updates/chancery-rejects-argument-for-jurisdiction-based-only-on-ownership-of-stock-in-delaware-corporation/

Chancery Refuses to Set Aside Valuation Performed Pursuant to Formula in Stockholders’ Agreement

Julian v. Julian, C.A. No. 1892-VCP (Del. Ch. March 22, 2010), read opinion here. This is the latest in a series of decisions by the Court of Chancery in this case that involves litigation over the break-up of several affiliated family businesses. Prior Chancery opinions in this long-running internecine imbroglio have been highlighted here, here,here and here.

Three issues addressed by the Court of Chancery in this opinion should be of particular interest to readers of this blog because they are likely to be of wide-ranging applicability for those dealing with valuations of closely held businesses based on a stockholders’ agreement in connection with a business break-up.

First, in the context of a valuation provision in a stockholders’ agreement, the Court was called on to determine if it had the power to alter or set-aside an appraisal done pursuant to that agreement but that one of the parties argued was flawed.

Second, the Court decided whether the reference to real estate holdings in the agreement, required a valuation to be done of interests that the company had in other LLCs which owned real estate (as opposed to the company owning the real estate directly).

Third, the Court  explained the principle known as “course of performance” as a method to interpret an otherwise ambiguous contract. The Court decided many other issues in this ruling that are likely to be of the sui generis variety and so will not be covered in this overview.

Contract Interpretation Principles.

After reciting the well-known principles of Delaware’s objective theory of contracts, whose goal is to determine the intent of the parties as expressed in the clear language of the document, the Court next addressed what to do when the language of the parties’ agreement is not so clear. If there are two reasonable interpretations of the agreement, it is deemed ambiguous and the Court may then consider factors outside the four corners of the document. In determining the intent of the parties in light of ambiguous language, the Court may consider the following objective evidence:

“the overt statements and acts of the parties [e.g., the drafting history of a document], the business context, the parties’ prior dealings and industry custom.” (See fn. 37)(brackets are mine).

In this search, the Court cited to the Restatement (Second) of Contracts for the principle that: “…courts should consider the parties’ course of performance as the ‘most persuasive evidence of the [meaning of] the parties agreement’” See fn. 38 (brackets in original). Footnote 38 also cites to a case that is quoted for the following statement of Delaware law: “Course of performance …may also be used to supply an omitted term when a contract is silent on an issue.”

In connection with the foregoing, the Court of Chancery examined correspondence among the parties to the agreement that preceded the amendment of the agreement at issue in this case. The Court also examined communications among the parties after the amendment to the agreement was signed to review how the parties referred to and understood the provisions in the agreement at issue in this case.

The Court quoted from Black’s Law Dictionary and a standard English dictionary in its analysis of the word “hold” in order to determine if the phrase “real estate held by the company” should include options to buy real estate (no), and interests in other entities that owned real estate (yes).

Review of Appraisal Report based on Valuation Formula in Stockholders’ Agreement

The parties wanted the Court to invalidate certain appraisal reports performed ostensibly pursuant to valuation formulae in the parties’ stockholders’ agreement. The Court refused to examine the minutiae of the myriad aspects of the disputed appraisals, but instead reviewed them in the same deferential manner that it would review the decision of an arbitrator in light of the similarity between the decision of an appraiser and the decision of an arbitrator empowered by the provisions of an agreement among parties to a dispute. Of course, the Court’s work on this issue was made easier by the consent of the parties to this review standard due to the absence of any procedure in the agreement that addressed the circumstances under which a party could challenge an appraisal submitted by another. See footnotes 81 and 82.

Specifically, the parties agreed that the Court should only set aside an appraisal in this context where there is evidence that the appraisal is the product of fraud, bad faith, partiality or deception.

Despite arguments that the appraiser did not consider all relevant factors and did not comply with the applicable MAI standards, the Court did not find that the allegations rose to the level of fraud, bad faith, partiality or deception, and thus refused to set aside or modify the appraisals at issue.

Although footnote 82 refers to cases that recognize the notion that Courts have greater authority to review contractually-provided appraisals than arbitration awards, footnote 83 discusses the comparably high threshold under the Delaware Uniform Arbitration Act at Sections 5714 and 5715 of Title 10 of the Delaware Code, that must be met before a Court may either vacate or modify an arbitral award.(e.g., when the arbitrator exceeded her authority or the arbitrator ruled on an issue outside the scope of matters submitted to her.)

Sub-Issue: What if a second appraisal obtained by the parties is for an amount less than the challenged one? Answer: It can be discarded if not formally submitted.

An ancillary issue arose in the context of a provision in the agreement that allowed a party who disagreed with the MAI appraiser of one party, to obtain a second MAI appraisal and the two would be averaged. However, in this case, the party who obtained a second MAI appraisal apparently later realized that his MAI appraisal turned out to be lower than the original MAI appraisal obtained by the adverse party he was challenging.

Thus, the issue presented was whether he was “stuck” with the second appraisal he obtained (which would have been averaged with the first one and lowered the amount payable to him), or if he could “take it back” and decide not to use the second one he obtained.

The Court reasoned, based on the wording of the agreement that did not require the second “challenger” appraisal to be “averaged with the first appraisal” unless it was formally submitted to the opposing party for that purpose, and because the “the party that initially wanted to challenge the first appraisal” did not “formally submit the second appraisal”, it was not required to be used to “average out” the first appraisal. Apparently, the reason he obtained a second appraisal, is because he regarded the first appraisal as confusing and did not realize that the first appraisal resulted in a higher valuation than he had thought.

Sub-Issue: May a settlement offer still be accepted after new Counteroffer is made? No

The Court discussed whether a settlement offer could still be accepted after a counteroffer was made. Footnote 94 cites to cases that stand for the basic contract law that, generally speaking, a counteroffer is a rejection of the offer and “terminates the power of acceptance” if it is not identical to the terms of the offer.

Although other ancillary issues are addressed by the Court, the foregoing are the only ones that are likely to be of widespread interest or application by readers of this blog or those engaged in business litigation for a living (or “students” of corporate law generally).

Chancery Allows Claim to Proceed for Nullification of Certificate of Cancellation Due to Failure of Dissolving Entity to Provide Adequate Reserves for Known Liabilities; Court Rejects Argument that Likely Bankruptcy Makes Nullification Futile

Thor Merritt Square, LLC v. Bayview Malls, LLC, C.A. No. 4480-VCP (Del. Ch. March 5, 2010), read opinion here.

Overview

In this decision, the Court of Chancery allowed a claim to proceed for nullification of a Certificate of Cancellation of the Certificate of Formation of the entity involved, due to pending unresolved liabilities and a failure to provide for adequate reserves for those known liabilities.

Background

This case arises out of the alleged failure of one party to a purchase and sale agreement for a shopping center, to perform or pay for work required under that agreement. Two of the defendants were sellers of the shopping center. The agreement required separate entities referred to as “Bayview Malls” and “Holdings” to perform certain work to bring stores into compliance with the applicable fire code. However, despite Bayview Malls and Holdings never performing the work and refusing to pay for the work when it eventually was performed by the plaintiffs, both Bayview Malls and Holdings terminated their existence without ever paying for, or making reasonable provision for payment of, the required work.

Plaintiffs sued parties described as “defendants John Doe 1-22, as managers and members of Bayview Malls and Holdings.” Although the Court did not decide the issue, the plaintiff withdrew its claim against John Doe defendants in connection with an argument no such procedure was permissible in Delaware.

On a procedural level, the Court denied the Motion to Dismiss or in the alternative for Stay of the claim for nullification of a Certificate of Cancellation.

Defendants’ position on the request for nullification was based on three grounds: (1) The provision for unmatured contract claims was made by putting funds in escrow and that was sufficient for Section 18-804(b) of Title 6 of the Delaware Code; (2) Reviving the dissolved entities would be futile because they had no assets and would file for bankruptcy; and (3) The nullification claim should be barred by the analogous statute of limitations.

Legal Analysis

The Court reviewed the familiar standard under Rule 12(b)(6) for a Motion to Dismiss and then recited the requirements under Section 18-804(b) of the Delaware LLC Act which mandate that a reasonable provision be made for unmatured contractual claims. Specifically, that section provides in relevant part as follows: “A limited liability company which has dissolved: (1) Shall pay or make reasonable provision to pay all claims and obligations, including all contingent, conditional or unmatured contractual claims, known to the limited liability company.”

Reasoning

The Delaware LLC Act requires a dissolving LLC to make reasonable provision for the payment of unmatured contractual claims before filing its Certificate of Cancellation. See footnote 17 which also notes that Section 18-804(b)(3) requires a dissolving LLC to make provision not only for known liabilities but also for liabilities that “have not arisen but that, based on facts known to the limited liability company, are likely to arise or to become known to the limited liability company within ten years after the date of the dissolution.”

Based on the liberal Motion to Dismiss review standard, the Court was required to accept as true the allegations in the complaint that would support an inference that the defendants failed to make reasonable provision for unmatured claims. Moreover, assertions to the contrary were merely evidence of the existence of genuine issues of material fact as to reasonable provisions being made and those issues of fact could not be determined on a Motion to Dismiss.

The Court rejected the argument that a dissolved entity could not be sued after its Certificate of Cancellation became effective. The Court cited to prior decisions which held that Section 18-803(b) does not require dismissal of a complaint that seeks nullification on the ground that an LLC failed to wind-up in compliance with the LLC Act. See footnote 18 (citing Metro Communications Corp. BVI v. Advanced MobileComm Techs. Inc., 854 A.2d 121, 138-39 (Del. Ch. Apr. 30, 2004)).

In addition, the Court rejected the arguments of defendants on procedural grounds because the arguments were not included in their opening brief. See Ct. Ch. R. 7(b) and 171. See also footnotes 20 to 22.

In addition, the Court rejected the argument that the likelihood of filing for bankruptcy if the nullification claim prevailed would make the effort futile, because the nullification of the cancellation would still facilitate, for example, the ability of the plaintiffs to pursue their related efforts to pierce the corporate veil of the dissolved entities.

In sum, the Court allowed to proceed the claim to nullify the cancellation of the Certificate of Formation of the entities that failed to make adequate reserves for claims against them.

Court of Chancery Questions Special Litigation Committee’s Independence and Investigation; Denies Motion to Dismiss Litigation

In London v. Tyrrell et al., C.A. No. 3321-CC (March 11, 2010), read opinion here, the Court of Chancery denied a special litigation committee’s (“SLC”) motion to dismiss a shareholder’s lawsuit under Zapata Corp. v. Maldonado, 430 A.2d 779 (Del. 1981), because there were material questions of fact regarding: (1) the SLC’s independence, (2) the good faith of its investigation, and (3) the reasonableness of the grounds upon which the SLC recommended dismissal of the lawsuit.  A prior Chancery ruling in this case was highlighted on this blog here.

Kevin Brady, a highly regarded Delaware litigator, prepared this synopsis.

Background

In 1996, plaintiffs Craig London and James Hunt and defendants Patrick Neven and Walter Hupalo, and others founded iGov, a government contracting firm. In 2005, after changing its focus, iGov won a 5-year $300 million contract with the United States Special Operations Command (the “TACLAN” contract). Because of the expenses it incurred in reinventing itself, iGov’s CEO, Neven, hired Michael Tyrrell as a consultant (he later replaced London as CFO of iGov) to help iGov find a lender to supply it with an operating line of credit. Textron Financial surfaced as a possible candidate. Around the same time, defendants decided that it would be advisable to implement an equity incentive plan (the “2007 Plan”) for the benefit of key members of management. Chessiecap Securities, Inc. was retained to value iGov stock for purposes of setting the exercise price of options for the 2007 Plan.

The Valuation Rollercoaster

Throughout 2006, Tyrrell distributed a number of 2007 forecasts which reflected ever-changing EBITDA. On May 4, 2006, Tyrrell sent Textron a fiscal year 2007 forecast reflecting an EBITDA of approximately $3.5 million (the “First Textron Forecast”). On August 15, 2006, Tyrrell sent Textron an updated 2007 forecast showing an EBITDA of roughly $3 million (the “Second Textron Forecast”). On August 23, 2006 Tyrrell sent Chessiecap a 2007 forecast that showed an EBITDA which also had a value of approximately $3 million (the “Original Chessiecap Forecast”). On October 2, 2006, Chessiecap valued iGov equity at $5.5 million, however, Tyrrell told Chessiecap that in his view $5.5 million was “probably on the high side.” On October 18, 2006, Tyrrell sent Chessiecap a revised forecast that eliminated certain revenues and expenses and showed an EBITDA of $1.8 million (the “Revised Chessiecap Forecast”). On October 31, 2006, Chessiecap certified its Final Valuation of the equity of iGov at $4.7 million. Finally, on December 8, 2006, Tyrrell sent Textron another updated 2007 forecast that showed an EBITDA of approximately $3.1 million (the “Third Textron Forecast”).

London and Hunt are Removed as Directors

In January, a split in the board developed over the correct valuation to use. On January 7, 2007, Tyrrell sent an email to iGov management regarding a proposal to purchase London’s shares for $4 per share, but he wanted an updated valuation since he felt that iGov’s “valuation will likely be higher than $4.7 million [the Final Valuation]. . . .” On January 16, 2007, London objected to iGov relying on Chessiecap’s Final Valuation for purposes of the 2007 Plan because he felt the information upon which the Final Valuation was based was stale and inaccurate. On January 17, 2007, Hunt, who also believed the Final Valuation was unreliable, made an offer to buy all of Neven’s stock at $28 per share. Defendants Neven and Hupalo, who owned 42.5% of iGov’s voting stock, teamed up with iGov officer and shareholder Jack Pooley (collectively they owned 50.1% of iGov’s voting stock), and executed written stockholder consents removing London and Hunt from the board and electing Tyrrell to the board.

The 2007 Plan is Adopted

Defendants then engaged Chessiecap to prepare an addendum to its Final Valuation in which, among other things, Chessiecap concluded for the first time that the fair market value per share as of July 31, 2006 was $4.92. Defendants then held a special meeting of the iGov board on January 30, 2007 to consider the 2007 Plan under which the defendants were given 60% of the options granted and the plaintiffs were given no options or shares. The 2007 Plan also provided that the exercise price of the options could not be less than 100% of the fair market value of iGov common stock on the date the options were granted. Defendants unanimously voted as directors to approve the 2007 Plan and simultaneously adopted $4.92 per share as the fair market value of iGov shares on January 30, 2007 based on Chessiecap’s Final Valuation, dated July 31, 2006, and the associated addendum.

Former Directors File Suit

After the 2007 Plan was approved, plaintiffs filed a books and records action under 8 Del. C. § 220. Plaintiffs engaged the McLean Group, a valuation firm, to conduct separate valuations of iGov’s equity as of October 31, 2006 and December 31, 2006 (the “McLean Valuations”). In performing the McLean Valuations, McLean used the Second Textron Forecast rather than the Revised Chessiecap Forecast. The McLean Valuations placed the per share value of iGov equity at $13.32 on October 31, 2006 and $15.45 on December 31, 2006. Around this same time, iGov expanded the size of its board from three members to five, adding Vincent Salvatori and John Vinter. On October 31, 2007, after attempts to resolve the dispute failed, plaintiffs filed their complaint. In February 2008, the complaint was amended in response to defendants’ motion to dismiss. The plaintiffs claimed that the defendants breached their fiduciary duties of care and loyalty in that the defendants materially misrepresented iGov’s business prospects to Chessiecap in order to get a lower valuation for them to acquire iGov stock. The plaintiffs sought, among other things, rescission of the options granted to defendants under the 2007 Plan.

SLC Formed

On November 21, 2008, the iGov board formed a two-member SLC comprised of the two new board members (Salvatori and Vinter) to consider whether it was in iGov’s best interest to pursue the derivative claims in plaintiffs’ complaint. The SLC hired legal and financial advisors and conducted an investigation from April 2009 to July 2009. During the investigation, the SLC’s financial advisor (“SRR”) performed valuations of iGov as of October 31, 2006 and January 30, 2007 without reviewing the work done by Chessiecap and McLean. The SLC concluded that October 31, 2006 was an appropriate valuation date because it believed that Chessiecap’s Final Valuation was essentially current as of October 31, 2006, despite being dated July 31, 2006. The SLC determined that January 30, 2007 was an appropriate date because it was the date the challenged 2007 Plan was adopted. SRR also concluded that since iGov was worth $3.90 – $4.15 per share as of October 31, 2006 and $5.24 – $5.39 per share as of January 30, 2007, the $4.92 per share price was “within the range of fair market value” based on the SRR valuations.

SLC Recommends That the Lawsuit Be Dismissed

On August 5, 2009, the SLC filed a Report concluding that the suit was not in the best interests of the Company and recommending that it be dismissed. The SLC concluded that the defendants acted properly in adopting the 2007 Plan and did not breach their duties of care or loyalty. With regards to the duty of care, the SLC found that the 8 Del. C. § 102(b)(7) provision in iGov’s certificate of incorporation exculpates directors from personal liability not involving intentional misconduct or knowing violations of the law. The SLC concluded that a duty of care claim should not be pursued because any breach of care conduct, if it occurred, would be covered by the § 102(b)(7) provision. As to the duty of loyalty, the SLC concluded that defendants’ approval of the 2007 Plan and actions leading to that approval would satisfy the entire fairness standard because the process employed was fair and the $4.92 price was fair. The SLC also determined that no rescission of the options granted under the 2007 Plan was necessary because $4.92 was in the range of fair market value.

Two-Step Analysis under Zapata

Under the Delaware Supreme Court’s decision in Zapata Corp. v. Maldonado, 430 A.2d 779 (Del. 1981) there is a two-step analysis that must be applied to the SLC’s motion to dismiss. First, the Court must review the independence of SLC members and whether the SLC conducted a good faith investigation of reasonable scope that yielded reasonable bases supporting its conclusions. In the second step, the Court applies its own business judgment to the facts to determine whether the corporation’s best interests would be served by dismissing the suit.

Independence Questioned – “Caesar’s Wife” or “My Cousin Vinter”

The Court noted that an SLC member is not independent if he or she is incapable, for any substantial reason, of making a decision with only the best interests of the corporation in mind. Quoting the Supreme Court’s decision of Beam v. Stewart, 845 A. 2d 1040, 1055 (Del. 2004):

Unlike the demand-excusal context, where the board is presumed to be independent, the SLC has the burden of establishing its own independence by a yardstick that must be “like Caesar’s wife”-“above reproach.” Moreover, unlike the presuit demand context, the SLC analysis contemplates not only a shift in the burden of persuasion but also the availability of discovery into various issues, including independence.

In this instance, it was undisputed that neither Salvatori nor Vinter had a personal stake in the challenged transactions and neither faced any risk of personal liability in this action. However, the Court was troubled by the fact that Vinter was related to Tyrell (Vinter’s wife was Tyrell’s cousin) and Salvatori used to work for Tyrell.

While the Court admitted that it was not possible, at this stage of the proceedings, to say unequivocally that either Vinter’s or Salvatori’s independence was impaired, the burden was on them to show no material question existed about their independence.

The Court determined that they had failed to meet that burden. Moreover, the Court noted that there was evidence to suggest that Vinter and Salvatori may not have conducted their investigation objectively after having considered plaintiffs’ claims. In concluding that the SLC failed to satisfy the independence prong of Zapata, the Court stated that members of an SLC “should be selected with the utmost care to ensure that they can, in both fact and appearance, carry out the extraordinary responsibility placed on them to determine the merits of the suit and the best interests of the corporation, acting as proxy for a disabled board.”

“Scope” of Investigation and “Bases” for Conclusion Questioned

To conduct a good faith investigation of reasonable scope, the Court stated that the SLC had to investigate all theories of recovery asserted in the plaintiffs’ complaint and explore all relevant facts and sources of information that bear on the central allegations in the complaint. If the SLC failed to do that, the result would raise a material question about the reasonableness and good faith of the SLC’s investigation.

Here the SLC concluded that § 102(b)(7) provisions such as iGov’s are routinely upheld by Delaware courts and that such a provision protects defendants from personal liability, in the form of money damages, for gross negligence. However, the Court rejected the SLC’s conclusion stating “I find this to be an unreasonable conclusion because the SLC failed to consider that the requested relief in plaintiffs’ complaint is not limited to money damages; it specifically requests that the 2007 Plan be rescinded. Under Delaware law, exculpatory provisions do not bar duty of care claims ‘in remedial contexts . . ., such as in injunction or rescission cases.’

The SLC also concluded that plaintiffs’ duty of loyalty claims should be dismissed because it believed that the 2007 Plan was entirely fair to iGov — (1) the process defendants’ employed to secure approval of the 2007 Plan, particularly the process employed to develop the exercise price, was entirely fair, and (2) $4.92 was a fair exercise price. The Court disagreed finding that it was not acceptable for Tyrell to provide Chessiecap with the Revised Chessiecap Forecast showing an EBITDA of $1.8 million while simultaneously providing Textron with multiple iterations of EBITDA forecasts. The Court stated that this type of behavior in the current economic environment was particularly troubling:

As is evident from the SLC Report, the SLC concluded that the process of adopting the 2007 Plan was fair primarily because the SLC believes it was perfectly normal for Tyrrell to provide “optimistic” and “art of the possible” forecasts to Textron and use those forecasts internally, while at the same time providing a forecast to its valuation expert that was “substantially lower” but something the Company could “actually achieve,” rather than being “wishful.” To put it mildly, this is an interesting conclusion, especially in light of the current credit environment. One would suspect that lenders would prefer a forecast projecting what management believes is actually achievable as opposed to wishful.

The Court also identified a number of questions which were not adequately investigated by the SLC, including: (i) why did Tyrrell provide Chessiecap with the Original Chessiecap Forecast (showing an EBITDA of roughly $3 million) if he did not believe that the projections in that forecast were actually achievable? and (ii) why did Tyrrell provide Textron with the Third Textron Forecast (showing an EBITDA of 3.1 million) after he provided Chessiecap with the Revised Chessiecap Forecast (showing an EBITDA of $1.8 million)?

As to “Fair Price,” the Court questioned how the SLC could determine that both the Chessiecap Final Valuation and McLean Valuations were “tainted” and as a result, the SLC did not rely on either valuation (or any other valuation) in concluding that $4.92 was a fair price. Since the SLC had no professional valuation upon which to rely, the Court found that a material question of fact existed about whether the SLC had a reasonable basis to conclude that $4.92 was a fair price. Finally, with respect to the second prong of Zapata, since the Court found that the SLC failed the first prong of Zapata, the Court noted that it was unnecessary to continue the analysis because the result would not change.

SUPPLEMENT: Professor Bainbridge refers here to a review of the case by Theodore Mirvis and then the good professor suggests that the Delaware standard applicable in this case could benefit from some tweaking to address the unwieldy nature of the formulation of the standard.

Chancery Changes Co-Lead Counsel in Revlon Class Action

In Re Revlon, Inc. Shareholders Litigation, Consol. C.A. No. 4578-VCL (Del. Ch. March 16, 2010), read opinion here. This is a Court of Chancery opinion that is certain to generate copious commentary. The Court removed the original Co-Lead Counsel and appointed new Co-Lead Counsel for the class.

A cursory review makes it clear that this opinion is destined to be cited often for several reasons. For example, it describes the practice and some history of firms who file class actions in the Court of Chancery very soon after a public announcement of a transaction and the ensuing battle for lead counsel among firms filing competing complaints involving the same contested transaction. Footnotes refer to law review articles and prior Chancery decisions that chronicle the issues that arise in this context, often involving the same firms that the Court refers to as “frequent filers” in this Court. The Court also refers to this phenomenon as the “opening steps in the Cox Communications Kabuki dance.” (Slip op. at 8.)

The opinion includes scholarly analysis regarding the criteria employed by the Court in its selection of lead counsel in class actions, noting that the size of plaintiff’s holding is not always determinative. Without any intent to “name names” and having no interest in identifying firms on this blog that suffered in this case, it must be noted that the Court concluded that original counsel did not “provide adequate representation.”

The Court cites to many academic sources that discuss the policy issues that arise in these types of cases, as well as the “pros and cons” of what the Court refers to as “entrepreneurial litigators” who have a portfolio of class action cases. There is much more to commend this decision as must-reading for any lawyer or plaintiff who files a representative action in the Delaware Court of Chancery. A fuller synopsis will follow soon.

Although this remarkable opinion is only 44-pages in the “slip opinion format,” it speaks volumes about the practical and theoretical aspects of representative litigation, as well as the standards that the Court enforces on all counsel that appear before it.

Much of the opinion discusses the types of class actions that arise in the context of what the Court referred to as the Cox Communications ritual, referring to the case of In re Cox Communications, Inc., 879 A.2d 604, 608 (Del. Ch. 2005). That “ritual” as to the Court describes it, involves a common practice in many representative suits that are hastily filed very shortly after the announcement of a controlling shareholder transaction. The Court has referred to these hastily prepared and hastily filed complaints as part of the “medal round of filing speed Olympics to seek lead counsel status.” See footnote 2. In footnotes 1 and 4, the Court cites to a law review article that refers to an academic analysis that concluded: “Firms who are early filers are frequently early settlers,” (leading some wags to label them “Pilgrims.”) In addition to referring to it as a ritual, the Court also refers to the situation in this case as “part of a Cox Communications Kabuki dance which involves two tracks.” The first track involves representative counsel doing “not very much” in the litigation, while the controlling shareholder and the special committee for the company move forward along the transactional track.

That procedure followed form in this case with a twist. The financial advisor for the Special Committee indicated that it would not be able to render a fairness opinion for the transaction and the Special Committee therefore could not recommend the proposed transaction. However, the controlling shareholder in the company did a “end run” around the Special Committee by proposing a slightly new transaction to the whole entire board and not the Special Committee. Thus, the Special Committee declared that its work was complete and disbanded.

Although the board declined to make any recommendation to stockholders on whether or not to tender their shares, the board did authorize Revlon to proceed with the proposed transaction.

The Litigation Track Restarts and the Parties Enter into a Memorandum of Understanding

The Cox Communications ritual was described by the Court as follows: Once the corporation and the controlling shareholder reached an unofficial agreement on the terms of the transaction, the plaintiffs were brought in to “bless the deal.” The transaction provided for consideration for a settlement and the payment of attorneys’ fees and a broad transaction-wide release for all defendants. The minor tweaks in the transaction followed in what the Court called this “traditional choreography.” The transactional tweak traditionally involves lowering the termination fee which would only become operative in the event of a topping bid and supplemental disclosures which provide convenient ways to settle litigation over a deal that has already been exposed to the market for some time, by which point it is relatively clear to the parties that an interloper is unlikely to appear.

Importantly, one of the tweaks made in this case by the parties was already required by Delaware case law in order to render a controlling stockholder tender offer as non-coercive. The court suggested that the provision would have been included anyway as a requirement under Delaware law that a controlling stockholder tender offer be conditioned upon tenders from a majority of the outstanding unaffiliated shares. The Cox Communications case is known for requiring that if a tender offer by a controlling shareholder is to be considered no-coercive, when enough shares are tendered such that the remaining holders can be eliminated for a short-form merger, then the squeezed-out stockholders would receive securities and the surviving corporation substantially identical to the shares it would have received.

The court regarded the changes to the ultimate terms of the deal as being the result of very little if any influence by the plaintiff’s counsel and the Memorandum of Understanding (MOU) exaggerates the role of counsel in obtaining settlement. The Court refers throughout the opinion to “Old Counsel” as the counsel that it replaced.

New Actions Filed

After the MOU was entered into, new representative actions were filed that challenged the transaction. Unlike the original actions filed by Old Counsel, Fox challenged a negotiable proposal, the new actions challenged in actual transaction. New counsel argued that there was a conflict between the positions of the tendering stockholders that they represented and the non-tendering stockholders represented by the Old Counsel.

The Court quoted extensively from terms of the Amended Complaint filed by plaintiffs’ Old Counsel with a purpose to protect “defendant’s turf and the settlement” which was inconsistent with the record before it.

The Court was also critical of defense counsel who supported the settlement and also made statements to defend the settlement that the Court regarded as “not quite accurate” (my phrase).

Legal Analysis

The Court cites to a treatise and to several federal decisions to support its statement that the Court has both the power and the duty to either select or remove class counsel. Although there may not be substantial case law in the Court of Chancery on this topic, comparatively speaking, the Court cited to several cases which list the factors that are important in choosing lead counsel, such as the quality of the pleading, the willingness and ability to litigate vigorously on behalf of an entire class, and the enthusiasm or vigor with which the various contestants have prosecuted the lawsuit. See Hirt v. U.S. Timberlands Serv. Co., 2002 WL 1558342 at *2 (Del. Ch. July 3, 2002) and Wiehl v. Eon Labs, 2005 WL 696764, at *1 (Del. Ch. May 22, 2005). Notably, the Court emphasized that the size of plaintiff’s share ownership is not a determinative factor in selecting lead counsel.

Transaction was not a Voluntary, Non-coercive Tender Offer that Avoided Entire Fairness Review

The Court made it clear that this was not a transaction that avoided entire fairness review based on the case of In Re Siliconix, Inc. Shareholders Litigation, 2001 WL 71677 (Del. Ch. June 19, 2001). The Siliconix case rests in part on the non-involvement of the target board from the Delaware corporate law perspective. Rather, as a series of cases noted, corporate action by the target board takes a transaction out of the Siliconix framework. See, A.G. Andra v. Blount, 772 A.2d 183, 195 n. 30 (Del. Ch. 2000).

The Court also noted other reasons why the entire fairness standard would apply to the deal in this case in part because none of the following safe harbor provisions applied: (1) There was no affirmative recommendation from an independent committee of the target board; (2) It was not subject to a non-waivable condition that a majority of outstanding unaffiliated shares tender; and (3) There was no commitment by the controller to effect a prompt back-end merger. Moreover, in this case the outside directors believed that they could not obtain a fairness opinion for the deal. The Court observed that if there was ever a case that warranted the entire fairness review standard, this may be one of those cases.

Policy Considerations

The Court recognized the important role of representative cases as a check on management, and that many cases achieve meaningful results. The Court recognized also the sound policy reasons for the Court to police representative counsel.

At footnote 6, the Court cited to multiple law review articles, and addressed the pros and cons of representative cases and what the Court refers to as “entrepreneurial litigators” who specialize in handling these types of cases. This opinion made it clear that the Court will act as a very “strict policeman,” and the Court recognizes that one possible consequence of that approach would be that “frequent filers” may accelerate their efforts to populate their portfolio of cases by filing in other jurisdictions. The Court recognized also that while “in the short run policing frequent filers may cost some members of the bar financially, in the long run it enhances the legitimacy of our State and its law not to facilitate a system of transactional insurance through quasi-litigation.”

The Court requires New Counsel to Perform Confirmatory Discovery

In addition to appointing new lead counsel, the Court specifically at pages 43 and 44 outlined in detail minimum discovery that new counsel had to conduct through both traditional written discovery methods and through depositions in this case. The itemized description on pages 43 and 44 of the slip opinion is in some ways unique to this case, but it provided a road map for confirmatory discovery that will be a useful reference in some respects for representative counsel seeking to have the Court approve class action settlements in the future.

UPDATE: I want to draw readers’ attention to two transcripts of subsequent hearings in separate, unrelated cases by the same author of this opinion, here and here, where the Court “softened the impact” of the references in this opinion to some of the firms involved in this case in a manner that would tend to prevent use of the opinion against those firms in the future. The ruling in this case, and the above-linked transcripts, are indications of the special emphasis that the Court places on the role of Delaware lawyers in a case populated with many “out of town counsel.” See the complete summary at the following link:

https://www.delawarelitigation.com/2010/03/articles/chancery-court-updates/chancery-changes-colead-counsel-in-revlon-class-action/

Agreement Terminable at Will Not Subject to Statute of Frauds

Dweck v. Nasser, C.A. No. 1353-VCL (Del. Ch. March 10, 2010), read letter decision here.

Prior decisions of the Court of Chancery involving this matter have been highlighted on this blog here.

This short three-page letter decision refused to apply the Statute of Frauds to an oral agreement that was terminable by either party at any time “upon performance of an act which is within the control of one of the parties.” The Court reasoned that because the “performance of the agreement could be completed within one year without breach by either party”, the Statute of Frauds did not bar its enforcement.

In a previous decision in this matter, the Court of Chancery ruled that the oral agreement still being disputed in the instant ruling, (which is based in part on an unsigned draft shareholders’ agreement), could not serve the purpose of a “voting agreement” due to the requirement of DGCL Section 218(a) that voting agreements or voting trusts be in writing. Nonetheless, the Court observed, nothing prevents the application of another state’s contract law, such as New York in this case, to issues such as contract formation at the same time that the DGCL governs the validity of the corporate governance implications of the contract. (The Court also notes parenthetically its preference on how to deal with a motion to amend pleadings.) See the complete summary at the following link:

https://www.delawarelitigation.com/2010/03/articles/chancery-court-updates/agreement-terminable-at-will-not-subject-to-statute-of-frauds/

Delaware Court of Chancery Imposes Personal Jurisdiction on Singapore Resident Serving as LLC “Manager” per Section 18-109 of LLC Act

PT China LLC v. PT Korea LLC, No. 4456-VCN (Del. Ch., Feb. 26, 2010), read letter decision here. Many thanks to Peter Ladig, one of the Delaware counsel of record in this case, for forwarding this decision to me the same day it was issued. (The photo below is of the Kent County Courthouse, where the Court of Chancery hears cases in Dover, although a new Courthouse is under construction.)   This 29-page decision should be included in the tool box of every Delaware litigator who needs to know about obtaining jurisdiction over a “manager” of a Delaware LLC who may not have any other contacts with Delaware.

Threshold Issue: Whether personal jurisdiction can be imposed on a Singapore resident based on Section 18-109 of the Delaware LLC Act, and if so, if the exercise of such jurisdiction comports with due process prerequisites?

Consent Statute for LLC Managers

Analogous to the consent statute for directors of corporations at 10 Del. C. Section 3114, managers of Delaware LLCs are deemed to consent to the personal jurisdiction of Delaware courts pursuant to Section 18-109 when they agree to serve as a manager of an LLC, and when the suit is “involving or related to the business of the limited liability company or a violation by the manager…of a duty to the limited liability company, or any member….” Even so, due process must still be satisfied.

“Manager” is defined broadly in Section 18-101(10) to include a person who “participates materially in the management of the limited liability company.” Obviously this covers a rather broad class of people, including one who may not be formally bestowed with the appellation of manager as that term is often used in a colloquial sense.

Is Due Process Satisfied if Section 18-109 Imposes Jurisdiction for Claims “Relating to Business and Affairs of the LLC” as compared to Fiduciary Duty Claims Against a Manager?

Delaware Courts have previously determined that if claims against a manager of an LLC relate to his or her fiduciary duty obligations, then due process considerations are satisfied when Section 18-109 is used to imposed jurisdiction. See footnote 22 and cases cited. The more nuanced issue in this case is whether the same conclusion can be reached when the claims are not necessarily based on fiduciary duty violations. Prior cases suggest a consideration of three factors to address this issue: (i) do the allegations focus on the rights, duties and obligations of the manager; (ii) is the matter “inextricably bound up in Delaware law”; and (iii)  Delaware has a strong interest in providing a forum for disputes relations to actions of managers of a limited liability company formed under its law in discharging their managerial functions.

Sub-Issue:  Do Contractual Claims Bar Fiduciary Duty Claims Based on the Same Conduct due to the “Primacy of Contract Law in Delaware” over Fiduciary Claims Involving Matters Based in Contract Rights and Duties.

Prior decisions of this Court have recognized that “a contractual claim will preclude a fiduciary duty claim, so long as ‘the duty sought to be enforced arises from the parties’ contractual relationship'”, due to the primacy of contract law. See fns. 32 to 34 for cases cited. The appropriate question to ask in order to analyze this issue is “whether there exists an independent basis for the fiduciary duty claims apart from the contractual claims, even if both are related to the same or similar conduct.” See fn. 34.

The Court explained that it was not necessary to find that the claims against the manager were based on fiduciary duties in order to apply Section 18-109 to impose jurisdiction. Rather, so long as the action “involves the manager’s rights, duties, and obligations to the company”, due process will be satisfied under the consent statute. See fn. 35.  There was no issue in this case about whether the operative agreement limited fiduciary obligations and related liability. Compare generally, Kelly v. Blum decision by Chancery highlighted earlier this week here.

The Court reasoned that the instant dispute is “intertwined with the defendant’s [manager’s] managerial position”, and coupled with “… the potential usefulness of his involvement in this suit, and Delaware’s interest in adjudicating disputes involving the management of its limited liability companies…”, the Court found justification for exercising jurisdiction in this matter consistent with “constitutional standards of fairness and substantial justice.”  See fns. 43-44. See generally, In Re USACafes, L.P. Litigation, 600 A.2d 43, 52-53 (Del. Ch. 1991). The Court noted parenthetically, however, that it was not passing judgment on whether the contract-based claims would prevail at a later stage of the proceedings in terms of being plead sufficiently. See the complete summary at the following link:

https://www.delawarelitigation.com/2010/02/articles/chancery-court-updates/delaware-court-of-chancery-imposes-personal-jurisdiction-on-singapore-resident-serving-as-llc-manager-per-section-18109-of-llc-act/

Chancery Analyzes Fiduciary Duties of LLC Members and Managers in Merger Context

Kelly v. Blum, No. 4516-VCP (Del. Ch., Feb. 24, 2010), read opinion here. This 49-page opinion of the Delaware Court of Chancery deserves more extensive treatment–that I hope to provide soon, but for the time being, I will highlight a few bullet points regarding issues of law addressed by the Court that warrant closer reading for most lawyers who make their living in the fields of business litigation.

• Confirmation of prior Delaware decisions that in the absence of an LLC Agreement provision to the contrary, both members and managers of an LLC owe traditional fiduciary duties of loyalty and care to each other and the entity. See footnote 69.

• The Court found “substantial compliance” with a notice provision in the agreement to be sufficient. See pages 22 and 23.

• The two exceptions to the requirement of being a member or shareholder before pursuing a derivative action.

• Analysis of whether a claim is direct or derivative.

• Elements of a defamation claim.

UPDATE: Professory Larry Ribstein provides an insightful analysis of the case here (which may obviate the need for me to provide a fuller synopsis myself this weekend.)  His commentary is especially helpful on the issue of the prerequisites to waiving fiduciary duties. The good professor also discusses in a separate post here, in connection with this case and a recent NY case, whether the Delaware courts would allow, by agreement, the law of another state to apply to a Delaware LLC, contrary to the Internal Affairs Doctrine. See the complete summary at the following link:

https://www.delawarelitigation.com/2010/02/articles/chancery-court-updates/chancery-analyzes-fiduciary-duties-of-llc-members-and-managers-in-merger-context/

Court Grants Motion To Compel Discovery From Party’s Wholly-Owned Subsidiary Which Was Not a Party to the Litigation

Dawson, et al. v. Pittco Capital Partners, L.P., et al., No. 3148-CC (Del. Ch.,Feb. 15, 2010), read letter decision here. Kevin Brady, a highly regarded Delaware litigator, provided this synopsis.

In a short discovery-related letter opinion, Chancellor Chandler granted plaintiffs’ motion to compel full interrogatory responses from defendants related to, among other things, the factual and legal bases (including each element) of each defense of the defendants’ four affirmative defenses: failure to state a claim, laches, waiver, and unclean hands. Additionally, one of the defendants had apparently resisted production of documents that were in the possession of its wholly-owned subsidiary, which was not a party to this litigation. Apparently finding no Court of Chancery decision on point, Chancellor Chandler cited Delaware federal case law interpreting Federal Rule of Civil Procedure 34 noting that “Federal Court decisions are ‘of great persuasive weight in the construction of parallel Delaware rules’ due to the analogous nature of the Court of Chancery Rules and the Federal Rules of Civil Procedure.” The Chancellor rejected the defendant’s position and required it to produce the requested documents from the wholly-owned subsidiary.  See the complete summary at the following link:

https://www.delawarelitigation.com/2010/02/articles/chancery-court-updates/court-grants-motion-to-compel-discovery-from-partys-whollyowned-subsidiary-which-was-not-a-party-to-the-litigation/

Chancery Court Applies 20-year Statute of Limitations for Contracts “Under Seal”; Rejects Laches Defense. Defines “Inquiry Notice”

Whittington v. Dragon Group L.L.C., No. 2291-VCP (Feb. 15, 2010), read opinion here.

Previous decisions of the Delaware courts in the long line of cases involving this internecine warfare among family members fighting over their interests in various business entities, have been summarized on this blog and can be found here.

This latest iteration by the Delaware courts in this matter comes to us after remand by the Delaware Supreme Court involving an important High Court ruling that the applicable statute of limitations for claims on a contract “under seal” is 20-years. See summary of Delaware Supreme Court decision here.

In addition to defining laches and applying its elements such as “unreasonable delay,” the Court of Chancery in this decision concluded that laches would not bar a claim that was brought a little after 3-years from the date that “inquiry notice” was imputed, in light of the statute of limitations that was 20-years long.

Also helpful for litigators is the definition by the Court of Chancery of “inquiry notice” at page 11 of the slip opinion.

Also of practical use for future reference is the definition by the Court of Chancery of the doctrine called “law of the case” and how that compares and differs from the obligation of the trial court after remand by the Supreme Court to apply new rulings of law. See Slip Op. at 8 to 10. See the complete summary at the following link:

https://www.delawarelitigation.com/2010/02/articles/chancery-court-updates/chancery-court-applies-20year-statute-of-limitations-for-contracts-under-seal-rejects-laches-defense-defines-inquiry-notice/

Chancery Orders Dissolution of LP Based on “Not Reasonably Practicable” Standard in Section 17-802

Harris v. RHH Partners, LP, et al., No. 1198-VCN, (Del. Ch., January 27, 2010), read letter decision here. A prior decision in this case by the Delaware Court of Chancery was highlighted here.

Why This Short Ruling is Noteworthy

This decision in noteworthy because it applies a statute that, comparatively speaking, does not enjoy a copious body of case law interpreting it. The statute in question is the dissolution statute for LPs, Section 17-802 of Title 6 of the Delaware Code. Decisions interpreting this dissolution statute have also been applied by analogy to the counterpart statute in the Delaware LLC Act, Section 18-802. These statutes allow for one to petition to dissolve an LP or an LLC when: “it is not reasonably practicable to carry on the business in conformity with the partnership [or LLC] agreement.”

Background

This case involved two parties who owned an LP, called RHH Partners, that in turn owned the personal residence of the sole limited partner who owned 99% of the LP. The remaining 1% was owned by a former friend who was also the general partner. Harris, the 99% owner and general partner, was a New York lawyer by training and appeared in this case pro se, as did the general partner.

Court’s Reasoning

Despite a general purpose clause authorizing the LP to operate “for all lawful purposes”, the Court  found after hearing testimony that the purpose of the LP “was not entirely clear” though it likely evolved over time. The Court concluded that: “its purpose, however ill-defined, ceased to exist”, and therefore, based on Section 17-802, the court held that “it is not reasonably practicable for RHH to carry on the business in conformity with the partnership agreement.”

Moreover, the Court reasoned that: (i) leaving the two partners “in any kind of business relationship would serve no useful purpose”; and (ii) there is no apparent purpose for the LP; and (iii) using the LP as a vehicle to own Harris’ residence “has no cognizable relationship to any business purpose for which RHH might exist.”

Winding-up

Ordering dissolution did not end the discussion. For the winding-up aspect of the case, the Court divided ownership of the sole asset of the LP, the personal residence of Harris, in the same proportion as the two men owned the LP. Thus, Harris received a “99 % fee simple interest ” in the real estate, and the other partner received a “1% undivided fee simple interest”. The Court noted that before distribution of the assets could be made, Section 17-804 required that creditors be paid.

Postscript

Notwithstanding the unusual procedural aspect of both parties appearing pro se, thus resulting in a less developed factual record and fewer formal legal arguments presented, the issue the Court addressed is sufficiently important, and the case law on the dissolution statute sufficiently meager–by comparison to many corporate statutes for example, that this ruling merited a quick overview. See the complete summary at the following link:

https://www.delawarelitigation.com/2010/01/articles/chancery-court-updates/chancery-orders-dissolution-of-lp-based-on-not-reasonably-practicable-standard-in-section-17802/

Delaware Court of Chancery Explains Procedural Prerequisites to Rebut Business Judgment Rule Protection for Board of Directors; Defines “Interested” Director and Lack of Director “Independence”

Robotti & Co. LLC v. Liddell, No. 3128-VCN (Del. Ch., Jan. 14, 2010), read opinion here. See summary of Court of Chancery’s prior Section 220 decision involving these parties here.

This 43-page Delaware Court of Chancery decision could serve as a “mini-law review article” that explains the current Delaware law on a wide range of issues important to those involved in corporate derivative litigation, and directors who want to understand the standards by which their conduct will be reviewed by the courts.

Background

The factual and procedural background of this matter is that it is a class and derivative action challenging a stockholder rights offering (“Offering”). The shareholder plaintiff alleges that the directors of the company set the Offering at a deliberately and inadequately low price that would trigger anti-dilution provisions in the agreements governing the stock options and warrants of the controlling shareholder. The shareholder plaintiffs argued that the triggering of the anti-dilution provisions resulted in a benefit being enjoyed by the directors that was not shared by the other shareholders and therefore, was a self-dealing transaction. The Court found, however, that the complaint failed to state a claim because the anti-dilution provisions did not change or challenge the pre-existing contractual rights of the directors which left them in substantially the same position they were in before the rights Offering. Thus, the shareholder did not sufficiently allege disloyal conduct by, for example, showing that the directors acquiesced  to the wishes of the controlling shareholder.

This cursory review will simply highlight key aspects of the Court’s opinion so that the interested reader can decide to review the full text of the decision on their own at the above link.

Court’s Summary of Issues in Case and Its Four-Part Holding

The Court described this case as one that “ultimately boils down to an alleged breach of the duty of loyalty and whether or not the defendants obtained a personal benefit through the Offering.” The Court’s reasoning and analysis can be summarized in four parts: (1) The Court cannot draw a reasonable inference from the facts that the Offering’s trigger of the anti-dilution provisions and their effect upon the options worked a material personal gain to the directors at the expense of the public stockholders. Nor did the plaintiff plead sufficient facts to support a claim that the directors acted in bad faith by consciously disregarding their fiduciary duties. (2) Because the court cannot reasonably infer from the facts that the directors received a personal gain by way of the collateral consequences of the Offering or consciously disregarded their duties, their decision to consummate the Offering is protected by the business judgment rule. (3) Of equal importance, the plaintiff has not duly alleged that the controlling shareholder dominated the board as it approved the Offering. (4) The derivative claims were barred because the plaintiff failed to plead that the board of directors were either interested or under the control or domination of an interested party as of the time it asserted the derivative claims.

Court Declines to Convert Motion to Dismiss into Motion for Summary Judgment

Robotti requested that the Court treat the motion to dismiss by the defendants as one for summary judgment because the defendants relied upon documents that were neither integral to, nor incorporated within, the complaint. The Court declined the invitation to treat the motion as one under Rule 56 as opposed to Rule 12(b)(6), which would have given the parties a reasonable opportunity to present all material relevant to a summary judgment motion. The Court observed that matters beyond the complaint may generally not be considered in a ruling on a motion to dismiss except in the following instances: “(1) When such documents are integral to, and incorporated within, the plaintiff’s complaint; or (2) When the documents are not being relied upon for the truth of their contents.” See footnote 49.

Direct v. Derivative Claims

The opinion contains a thorough discussion and analysis of the differences between a direct as compared to a derivative claim. Referring to recent Delaware Supreme Court opinions on the topic, the Court explained that an initial inquiry in determining between a direct and derivative claim requires the following two questions to be addressed: “(1) Who suffered the alleged harm – – the corporation or the shareholders individually; and (2) Who would receive the benefit of the recovery or other remedy?” See footnotes 55 and 56.

The Court discussed the recent cases that have analyzed whether a dilution in the value of corporate stock and overpayment by fiduciaries is direct or derivative. The recent decision in Gentile v. Rossette, 906 A.2d 91 (Del. 2006) was described as involving a controlling shareholder who caused the company to issue the controlling shareholder’s stock in return for debt forgiveness. The Supreme Court in Gentile held that both the corporation and the shareholders were harmed by the overpayment and due to the dual nature of the harm, the claims in that class were both derivative and direct.

Analysis of Bad Faith and Breach of Duty of Loyalty Claims

The Court described a methodology for analyzing allegations of bad faith within the context of a duty of loyalty claim as being recently clarified by the Delaware Supreme Court in Lyondell Chemical Co. v. Ryan, 970 A.2d 235 (Del. 2009). The Court of Chancery explained as follows:

“Mere gross negligence, which includes the failure to inform oneself of available material facts, cannot constitute bad faith. Bad faith, and thus a breach of the duty of loyalty, can arise only when a fiduciary consciously disregards his or her responsibilities. The Court in Lyondell imposed a high standard on any plaintiff advancing such a claim, and recognized a “vast difference between an inadequate or flawed effort to carry our fiduciary duties and a conscious disregard of those duties.” It concluded that fiduciaries in this context breached their duty of loyalty only if they “knowingly and completely fail to undertake their responsibilities.”

In this case, the Court found that Robotti never claimed that the defendants “knowingly and completely” failed to undertake their responsibilities, nor may any such inference be drawn from the complaint.

Business Judgment Rule Applies

This opinion provides a robust discussion of the business judgment rule, its applicability, and the pleading requirements under Rule 23.1.

Notably, this is the first Delaware decision that cites to the current version of the highly regarded four volume treatise on the business judgment rule recently published by Stephen A Radin and which is cited at footnote 89 by the Court as follows: 1 Stephen A. Radin, et al., The Business Judgment Rule: Fiduciary Duties for Corporate Directors 110 (6th ed. 2009).

Referring to the Radin treatise, the Court defines the business judgment rule as follows:

“The business judgment rule, as a general matter, protects directors from liability for their decisions so long as there exists a ‘business decision, disinterestedness and independence, due care, good faith and no abuse of discretion and a challenged decision does not constitute fraud, illegality, ultra vires conduct or waste.’ There is a presumption that directors have acted in accordance with each of these elements, and this presumption cannot be overcome unless the complaint pleads specific facts demonstrating otherwise. Put another way, under the business judgment rule, the Court will not invalidate a board’s decision or question its reasonableness, so long as its decision can be attributed to a rational business purpose.” See footnote 91.

The Court found that Robotti had been unable to allege that defendants were interested in the transaction and it also failed to allege bad faith or conscious disregard of fiduciary duty. Moreover, although Robotti may have plead a failure to act with due care and on an informed basis regarding the transaction, such a conclusion would be unhelpful in light of the provision in the charter pursuant to Section 102(b)(7) which would preclude a claim for damages on that ground.

Demand Excusal

The Court also conducted an analysis under Rule 23.1 and found that the derivative claims did not satisfy that rule. Footnote 95 and 96 made it clear that the applicable time period to determine whether the pre-suit demand requirement was futile was when the first derivative claim was presented–which was in the second amended complaint. The composition of the Board at that time when the first derivative claim was filed made the Rales v. Blasband case applicable. See 634 A.2d 927, 933-34 (Del. 1993). Under Rales, the Court explained that the relevant inquiry is only whether the board can exercise its independent and disinterested judgment in responding to a demand, where, as here, the majority of the directors responsible for that decision have since been replaced.

Definitions to Determine “Interested” or “Independent” Directors

The Court provides a helpful discussion and definition of the term “interested” for purposes of pre-suit demand upon the board. Likewise for pre-suit demand purposes, the Court provides a useful definition to determine whether a director is “independent” for purposes of a pre-suit demand analysis. See footnote 98: “The mere fact that a director receives some benefit that was not shared generally by all shareholders is insufficient; the benefit must be material.”

For purposes of demand excusal analysis, rather, the plaintiff must show that the alleged benefit was “significant enough in the context of the director’s economic circumstances, as to have made it improbable that the director could perform her fiduciary duties to the . . . shareholders without being influenced by her overriding personal interest.” See footnote 99.

Regarding the independence of a director, the Court emphasized the contextual aspect of the inquiry, which requires a Court to ask “whether the directors are so ‘beholden’ to an interested director or interested controlling shareholder, that ‘their discretion would be sterilized.’ Motivations such as friendship may influence the inquiry, but in order for friendship alone to neutralize the independence of a director, the ‘relationship must be of a bias-producing nature.’” See footnote 101.

The Delaware Supreme Court has required that a complaint identify a relationship between a disinterested director and the interested director or controlling shareholder “that is so close that one could infer that the ‘non-interested director would be more willing to risk his or her reputation than risk the relationship with the interested director.’” See footnote 103.

The Court analyzed the factual situation as it related to each board member at the time the derivative claim was made in the second amended complaint, and found that the complaint did not adequately justify excusal of a pre-suit demand.

Conclusion

Thus, because the Court found that a majority of the board at the time of the derivative claim was both independent and disinterested, Robotti did not sufficiently plead demand futility and to that extent his derivative claims were dismissed. In addition, the claim for self-dealing by interested fiduciaries failed as a matter of law and the facts did not support an inference that the directors consciously disregarded their fiduciary duties or entirely abdicated their responsibilities. Therefore, the complaint was dismissed. See the complete summary at the following link:

https://www.delawarelitigation.com/2010/01/articles/chancery-court-updates/delaware-court-of-chancery-explains-procedural-prerequisites-to-rebut-business-judgment-rule-protection-for-board-of-directors-defines-interested-director-and-lack-of-director-independence/

Bylaws May Contain Conditions to Grant of Advancements Rights that Supplement Advancement Rights in Charter

Xu Hong Bin v. Heckmann Corp., No. 4802-CC (Del. Ch., January 8, 2010), read letter decision here. The Delaware Court of Chancery previously granted partial summary judgment in favor of Xu on one of the counterclaims by Heckmann. Read summary of that prior decision in this case here. This ten-page letter decision from the Delaware Court of Chancery contains important analysis and recitation of Delaware law on both advancement and indemnification.

Key Issue

One of the key issues addressed by the Court was whether the provisions in the bylaws that allow the board to impose reasonable conditions prior to advancing legal fees were consistent with or contrary to the right to advancement contained in the Certificate of Incorporation.

Legal Analysis

The Court determined that there was no violation of Delaware General Corporation Law Section 109(b) in connection with the provisions in the bylaws that allowed the board to impose reasonable conditions on advancement, for two reasons. First, because the Court determined that the bylaw provisions were drafted and made effective contemporaneous with the provisions in the charter regarding advancement rights. Second, both documents were in effect when Xu began his service as a director and he should have been aware of the advancement provisions when he began his service as a director.

The Court observed that there was no requirement in Delaware law that all of the terms regarding advancement rights to which a person is entitled must be in one document. To the contrary, no such authority was presented to the Court.

Moreover, in light of Xu previously prevailing on Count III of Heckmann’s counterclaims, the Court granted summary judgment in his favor for indemnification with respect to Count III.

However, the Court denied a request for “fees on fees” in the instant advancement proceedings because Xu did not prevail on his pending claim for advancement to the extent that the Court upheld the arguments of Heckmann on the issue of conditions precedent to advancing fees, contrary to the position argued by Xu–the net effect of which was to allow Heckmann to impose reasonable conditions prior to granting advancement rights.

Procedural Commentary

The Court observed as a procedural matter that fee advancement actions are especially appropriate for summary judgment proceedings because the entitlement of a party to advancement can be determined by applying the allegations contained in the pleadings to relevant corporate documents. Likewise, indemnification is also appropriate at the summary judgment stage where there are no material factual disputes germane to indemnification. See the complete summary at the following link:

https://www.delawarelitigation.com/2010/01/articles/chancery-court-updates/bylaws-may-contain-conditions-to-grant-of-advancements-rights-that-supplement-advancement-rights-in-charter/

Chancery Rules on Issue of First Impression: Preferred Shareholders Have Same Right to Bring Derivative Claims as Common Shareholders