A recent Delaware Court of Chancery decision addressed how the court will review claims against an independent and disinterested board for breach of the duty of loyalty in connection with a merger transaction. The opinion styled Kahn v. Stern, C.A. No. 12498-VCG (Del. Ch. Aug. 28, 2017), involved allegations made unsuccessfully, that the board of directors breached their duties as a result of side deals that allegedly were made in connection with a merger that personally benefited the directors in an inappropriate manner.  Allegations were also made unsuccessfully that insufficient information was provided to stockholders before a majority approved the merger by written consent.

The detailed facts are essential for a complete understanding of the decision by the court, however, for purposes of this short blog post a focus on the court’s analysis and its application of the legal principles involved has the most widespread usefulness.

A critical determination was the court’s finding that three of the five board members were considered independent and disinterested. That determination by the court impacted the standard of review that the court applied.

The court began its legal analysis with a review of the requirements that a complaint must satisfy in order to prevail on a motion to dismiss, which was the procedural posture in which the decision in this case was made. In particular, where, as here, there was no controlling or majority stockholder, and the court found that three out of the five directors were considered independent, the complaint was required to include “sufficient facts to show that a majority of the board of directors breached the fiduciary duty of loyalty.”

That is, because the court found that a majority of the board was not dominated or controlled by an interested party, the board enjoyed the presumptions of the business judgment rule.  Generally, under the business judgment rule, the court will not second-guess well-informed, independent and disinterested board decisions.  Notably, there was no enhanced scrutiny applicable because no Revlon claim was made that the board did not attempt to obtain the highest possible price for the company.

There was no issue whether two of the five directors were considered independent and disinterested. The determining factor was whether the third director, Joseph Daly, could be so described.

In the court’s analysis to determine whether Daly was “disinterested,” which would have resulted in a majority of the board not being disinterested, the court observed that the sole allegation regarding Daly was that he had a large, illiquid block of shares, and that he aligned himself with another stockholder that was supporting the sale of the company, and that Daly was excluded from the special committee.  Daly owned approximately 19.1% of the company, making him the largest single stockholder.  There is no allegation that Daly received different or unique consideration.  Nor does the complaint allege that he faced a liquidity crisis or an urgent need to sell his stock.  The complaint failed to plead a disabling interest of Daly because his incentives were the same as that of other stockholders:  to maximize the value of his interests.

The next issue was whether Daly was an independent director. The court explained that to plead a lack of independence, a plaintiff must plead facts that, if true, overcome the presumption of a director’s faithfulness to his fiduciary duties.  There was no detail in the complaint to support the conclusion that Daly was unable to “objectively make a business decision” concerning the merger.

The court reasoned that in the face of a majority of disinterested and independent board members, and an exculpatory charter provision, in order to survive a motion to dismiss and pursue a post-closing damages claim for breach of fiduciary duty, the plaintiff was required to plead facts making it “reasonably conceivable that a majority of a board acted in bad faith.”

Bad faith will be found if a “fiduciary intentionally fails to act in the face of a known duty to act, demonstrating a conscious disregard for his duties.”  Bad faith may also be found when “the decision under attack is so far beyond the bounds of reasonable judgment that it seems essentially inexplicable on any ground other than bad faith.”

The allegations that the board members approved the merger without knowledge of the side deals and that there were omissions and misstatements in the information provided to stockholders, was insufficient to establish bad faith.  The court reasoned that the complaint did not plead facts that created a reasonable inference of bad faith because the amount of the reduction in the merger price allegedly based on the side deals was never described in detail; more importantly, details to negate the good faith of the independent directors who approved the merger in light of the side deals was absent from the complaint.

The court found that there were insufficient facts in the complaint to support the allegations that the actions of the board members were made without the best interest of the corporation in mind, and there were also insufficient facts to support the argument that it was “reasonably conceivable that the board took action inexplicable on grounds other than bad faith.”

Regarding the disclosure omissions and misstatements, the court observed that if the issues were presented in a pre-closing request for injunctive relief, the court would have employed enhanced scrutiny to review the disclosure allegations, not to determine damages. In a pre-closing procedural context, unlike in the current procedural posture, if appropriate, the court would afford equitable relief in aid of a stockholder pursuing statutory voting or appraisal rights.

By contrast, in this post-closing request for damages, the focus is on whether the directors of the acquired entity are conceivably liable for damages based on a non-exculpated breach of fiduciary duty due to the alleged failure to make material disclosures. Specifically, that would require the plaintiff to point to facts in the complaint to support an inference that the board acted in bad faith in issuing the disclosures, implicating the duty of loyalty – – as opposed to a mere erroneous judgment in the failure to make a disclosure which would implicate the duty of care which in this instance is exculpated by a provision in the charter.

The court explained that in a post-closing claim for damages, information deficiencies that might be found material in support of a claim for injunctive relief pre-closing, may be insufficient to support a claim for damages where, as here, nothing in the record created an inference that the directors deliberately withhold information or disregarded a manifest duty.

A recent letter ruling is useful for commercial litigators for two contract interpretation principles that the Court of Chancery addresses in a business-like manner. In Frank Robino III v. Paul Robino; Charles Robino, et al. (Del. Ch. Aug. 16, 2017), the Court addressed:

(1)        What standard is applied when a person claims that an agreement is not binding due to duress and/or allegations of diminished capacity as a result of substance abuse, including intoxication;

(2)        When a settlement agreement reached during mediation that might not have all the complete formality and comprehensiveness of a typical agreement, can still be enforceable.

Overview

The procedural context of this case was a motion to enforce a settlement agreement that was reached after mediation. Both parties were represented by competent counsel during the mediation, and the court describes the mediator as one of the most experienced mediators in Delaware.  The court granted the motion to enforce a settlement agreement and rejected the two defenses presented.

Rejected Defenses

The first rejected defense was based on the asserted argument of duress as well as substance abuse that apparently included intoxication or inebriation. The court cited to Delaware case law explaining the burden of proof and the challenges in prevailing on such a defense, which was not successful in this case.

Key Holding

Regarding the mediation that resulted in a settlement agreement, the court found that the essential terms of the agreement were agreed to, in a signed document at the mediation. It was not clear whether a more formal and comprehensive agreement was contemplated, although the parties did attempt unsuccessfully to negotiate a more formal and comprehensive agreement after the mediation.  Nonetheless, the court found that the terms that were agreed to and signed at the mediation were sufficient to enforce it as a binding contract.

The Delaware Court of Chancery recently addressed a common type of claim in commercial litigation: Post-closing adjustments to the purchase price. Sparton Corporation v. O’Neil, C.A. No. 12403-VCMR (Del. Ch. Aug. 9, 2017).

Basic Facts: The claims in this case involved an assertion that the defendant directors changed the selling company’s accounts receivable after an amount was determined for an escrow account for post-closing adjustments–but the change was made prior to the closing, unbeknownst to the buyers. In essence, the court found that the allegations of fraud did not satisfy the prerequisites for specificity, and, in addition, a robust anti-reliance clause prevented claims based on representations outside the contract.

Key Takeaways

Anti-Reliance Provision and Fraud Claims

The most noteworthy statement of law from this decision, that has the most widespread application, is based on the strong anti-reliance provision in the agreement, and settled Delaware law that prevented claims based on misrepresentations outside the four corners of the agreement. The anti-reliance clause was quoted at length in the opinion and was very specific to the extent that the parties agreed that the sole and exclusive representations were those contained in the  agreement and that no representations outside the agreement were relied upon in connection with the purchase. (See footnote 44 which cited to the well-known Abry case on which the court’s reasoning was based.)

In addition, the court relied on the basic pleading prerequisites for fraud which require much more specificity than non-fraud claims require. In addition, the court distinguished the Osram case which noted that “a mere allegation that a defendant knew or should have known about a false statement is not sufficient to plead the requisite state of mind” for fraud.The court reasoned that in this case, none of the defendants personally represented the accuracy of the financial statements, and that they were not a position to know the veracity of the statements. Also, the plaintiff did not plead any particularized facts about the roles of the defendant in the company or the relationships of the defendants with management. Nor did the plaintiffs allege any facts to show that the defendants would be a position to know that the documents were falsely prepared.

Commercially Reasonable Efforts

Also noteworthy is the court’s treatment of a claim that “commercially reasonable efforts,” as required by the agreement, were not employed. The case law on the “commercially reasonable efforts standard” has been written about on these pages in connection with recent decisions, but because case law about that contractual standard is not fully evolved, I mention it here in passing even though the court’s discussion is not comprehensive. See Slip op. at page 15.The allegation was that it should have been self-evident that because certain actions did not take place by a certain deadline in the agreement, that the reason must have been the lack of an exercise of commercially reasonable efforts. The court rejected this conclusory allegation because it was not self-sufficient and did not satisfy the “reasonably conceivable test” under Rule 12(b)(6).

A recent decision of the Delaware Court of Chancery deals with a recurring source of litigation: Claims for post-closing contingent payments based on allegations that the requisite milestone was triggered.  The merger in Fortis Advisors LLC v. Shire US Holdings, Inc., C.A. No. 12147-VCS (Del. Ch. Aug. 9, 2017), involved novel pharmaceutical products that were designed to treat dry-eye conditions.

Key Facts: At the time of the merger, some of the products involved had not received complete, final FDA approval, and therefore post-closing payments were based in part on whether or not the necessary final approvals would be obtained, as defined in the agreement.

In essence, the court determined that the defendant’s reading of the contract was the only reasonable one, and therefore the motion to dismiss was granted.

Key Takeaways

• The court observed that when the dispositive issue is one involving contract interpretation and the contract has only one reasonable construction as a matter of law, a motion to dismiss is an appropriate procedural approach.
• Several fundamental contract interpretation principles were applied, including: (1) the canon of construction that to express or include one thing implies the exclusion of the other. In Latin the expression is expresio unius est exclusio alterius. (Note that there is also an important exception to this canon of construction–that was not applicable in in this case.) See footnote 30.
• The second key principle was that the court will not interpret an agreement in a manner that renders some of the terms superfluous. See footnote 32.
• The next principle that the court applied was of a procedural nature but of major importance. Namely, an argument raised for the first time in oral argument and not included in the brief will not be considered. The court cited settled law at footnote 32 that a party waives an argument by not including it in its brief.
• The court relied on the rule that when schedules are attached to and incorporated into an agreement, they form part of the entire agreement equal to the terms in the body of the agreement. See footnote 40. The court also relied on the settled rule of contract interpretation which requires that the court prefer specific provisions over more general ones. See footnote 60.

The recent Chancery decision in Buttonwood Tree Value Partners, L.P. v. R.L. Polk & Co., Inc., C.A. No. 9250-VCG (Del. Ch. July 24, 2017), is noteworthy for its application of the entire fairness standard to a controlling stockholder transaction, and the observation that exculpatory provisions barring director liability for violations of the duty of care do not apply to a defendant in his capacity as a controlling stockholder. See footnotes 91 and 92.

Key Facts: The Polk family collectively owned more than 90% of the common stock of the company; the directors connected with the Polk family exercised a control block; they engineered a self-tender that allowed them to maintain their control; they set the price through the use of a financial advisor that also did work for the Polk family; within around two years of the self-tender the remaining stockholders received extraordinary dividends amounting to 1/3^rd of the self-tender price, together with merger consideration of 300% of the self-tender price. Based on those facts, the court explained that the controlling defendants had the burden to demonstrate that the transaction was entirely fair at the time it was made. They were not able to satisfy that burden.

Key Takeaways 

• When a transaction involves self-dealing by a controlling stockholder the applicable standard of judicial review is entire fairness. That standard imposes on the defendants the burden to prove that the challenged transaction with the controlling stockholder was entirely fair to the minority stockholders.
• In this context, an exculpatory provision does not apply to the defense of such a challenged transaction by a controlling stockholder because it alleges breach of a duty of loyalty. But the exculpatory provision under Section 102(b)(7) applies to alleged violations of the duty of care.
• Notably, common familial relationships among holders of a majority of corporate voting power are not per se sufficient to establish a controlling group of stockholders.
• Likewise, directors and stockholders who are also family members are not necessarily presumed to vote together “as one undifferentiated mass with a single hypothetical brain.” See footnote 93.
• Even in the context of an entire fairness review, and in the presence of an exculpatory provision, each defendant must be the subject of well-pleaded non-exculpated claims – – that is, a breach of the duty of loyalty. Specifically, the liability of directors must be determined on an individual basis because the nature of their breach of duty, if any, and whether they are exculpated from liability, can vary for each director. See footnotes 100 and 101.
• Bad faith allegations in this matter did not survive a motion to dismiss. In order to sufficiently plead bad faith, it must be demonstrated that “disinterested directors were intentionally disregarding their duties or that the decision was so far beyond the bounds of reasonable judgment that it seems essentially inexplicable on any ground other than bad faith.” See footnote 102.
• Another noteworthy discussion in this opinion was the dismissal of a claim against a law firm for the company alleging the aiding and abetting of a breach of fiduciary duty of the board. The court explained that such a claim requires a knowing participating in the breach and damages proximately caused by that breach. The standard for such a claim is intentionally stringent and it turns on the proof of scienter of the alleged abettor.
• In addition, a claim for aiding and abetting must include factual allegations of knowing participation in a breach which requires that the third party act with the knowledge that the conduct advocated or assisted constituted a breach. Moreover, the element of knowing participation “ requires that the secondary actor have provided substantial assistance to the primary violator.” See footnotes 108 through 112.
• The court found that the law firm was not alleged to have knowingly participated in the alleged breaches by the board of their fiduciary duties. The court observed the obvious: “Almost all corporate boards retain law firms to advise them on significant transactions         . . . [I]f pleading a plausible breach of the duty on the part of the director or controller is also sufficient to implicate her lawyer as an aider and abettor, a significant and perverse chilling effect on the ability of fiduciaries to obtain legal counsel would result.”
• Also noteworthy in connection with the dismissal of similar claims against the financial adviser were the following two points: (1) There is no general duty on third parties to ensure that all material facts are disclosed by fiduciaries; (2) “Passive failure on the part of third parties to ensure adequate disclosures to stockholders, without more, cannot support an inference of scienter for knowing participation in a breach.”

This post was prepared by an Eckert Seamans attorney.

The Court of Chancery recently awarded an applicant, Eric Pulier, all of his requested fees and expenses for advancement even though some of the expenses incurred related to the defense of claims asserted against SRS, a defendant not seeking advancement. In Pulier v. Computer Sciences Corp., No. 12005-CB (Transcript)(Del. Ch. Aug. 7, 2017), a former officer and director of ServiceMesh before its merger with CSC, Pulier, faced a civil suit alleging that he engaged in misconduct prior to the merger.  The background facts of this action were discussed more fully in a prior summary on these pages.

CSC defended against the advancement application on two grounds. First, CSC contended that the allegations against Pulier related to his individual conduct independent and separate from his status as an officer and director of ServiceMesh.  The Court quickly dispensed with this argument.

CSC next argued that two of Pulier’s four claims for advancement related to expenses incurred in defense of claims pending against SRS, and not against Pulier. CSC contended that these legal fees should not be advanced because they were not incurred for Pulier’s benefit.

Chancellor Bouchard granted all of Pulier’s requests for advancement, finding that the expenses incurred by Pulier against the CSC-versus-SRS claims “contain virtually identical allegations” to those claims raised against Pulier. Relying upon Fitracks, the Court found that CSC must indemnify Pulier for all of his legal expenses, which benefitted multiple defendants including Pulier and would have been necessarily incurred even if Pulier were the sole defendant.

Takeaway: The Court of Chancery continues to grant advancement claims to applicants even when only one of many parties is entitled to advancement when the legal bills incurred were necessary in the event the applicant were the sole defendant.  The Court of Chancery also continues to demonstrate reluctance to parse through the piecemeal minutiae of law firm bills for advancement defenses for allocation purposes.

A recent Delaware Court of Chancery opinion analyzed claims that are not uncommon: one of two founders of a start-up, that failed to launch, claimed that the other co-founder breached fiduciary duties by launching another start-up venture with a third-party who then pursued the business plan of the original start-up, but without the original co-founder.  In McKenna v. Singer, C.A. No. 11371-VCMR (Del. Ch. July 31, 2017), the court disagreed that the original co-founder of the original start-up entity had any right to an interest in the separate start-up venture later launched with a different third-party.

Background

The first 40 pages of this 69-page opinion offers detailed facts which are necessary to understand the court’s reasoning. The comprehensive background details explain why one co-joint venture partner decided not to do business with the other.  As an aside, one of the co-joint venture partners who was not a part of the eventual launching of the start-up formed with another third-party, exhibited a chronic failure to promptly reply to emails, as well as consistently dilatory behavior and failure to follow-up on tasks that were assigned to him as part of the due diligence for the start-up that was eventually launched with another third party.  That type of languid behavior did not endear him to the other entrepreneurs.

Key Takeaways

This opinion features iconic articulations of the basic elements of a fiduciary duty claim and eminently quotable descriptions of the fiduciary duties owed by directors or others serving in a fiduciary role to constituencies in a business venture. See Slip op. at 47.

Also useful for the toolbox of any corporate or commercial litigator is the application by the court of a fiduciary duty analysis to a former co-joint venture partner who decided to consummate the joint venture start-up deal with a third-party.

Of practical and widespread application is the court’s analysis of the unclean hands doctrine that barred relief based on the improper conduct by the party requesting relief. Slip op. at 41-42.  That is, but for the material misrepresentations of the plaintiff, the original joint venture partner never would have agreed to form a start-up entity.

Similarly helpful for commercial litigators is the court’s discussion of the duty of disclosure, if any, in an arm’s length negotiation, Id. at 43, as well as the standard for usurpation or misappropriation of a corporate opportunity. Id. at 48.

In sum, the court reasoned that the fiduciary relationship on which the request for relief rested was conceived in an unholy manner, due to the several material misrepresentations by the plaintiff that was requesting damages for the breach of an alleged fiduciary duty – – one that was never properly consummated due to the unclean circumstances created by the misdeeds of the plaintiff.