Duane Morris Delaware Business Law

A defining feature of Delaware corporations is board-centric governance. Stockholders’ participation in corporate governance is largely limited to voting in corporate elections, and directors’ accountability to stockholders, in most circumstances, is limited to the ballot box. As a result, bylaws enacted by a sitting board of directors which affect the election process have a special significance. But, while the Court of Chancery has shown a special sensitivity to corporate boards using their powers to meddle in the rules governing their own reelections, the recent Carroll v. Burstein, C.A. 2024-0317-LWW shows that to be viable, those challenges need to be grounded in a real-world contest to the directors’ reelections in most cases. When the challenge to election rules is instead purely abstract, Carroll makes clear that the court will rarely intervene.

As we have previously discussed on this blog, advance notice bylaws are a common feature of Delaware corporations. These bylaws require stockholders who are nominating election candidates to make disclosures about both the nominees and themselves prior to the meeting at which the election will take place. As the Delaware Supreme Court explained in the Kellner case last year, which we discussed on this blog, these provisions can provide beneficial transparency, allowing the stockholders to make a better-informed decision on corporate leadership. But, there remains a risk of an incumbent board using transparency as a pretext for imposing a needlessly burdensome advance notice process, or applying the advance notice rule in an unfair way, in order to entrench themselves in power. The Kellner decision discussed how Delaware courts should handle cases involving election bylaws which are valid in the abstract, but which in that instance were being enacted or applied by a board for improper, selfish motives.

Carroll addresses the reverse situation. Here, as has also recently happened at many other companies, the board revisited and revised its advance notice bylaw in reaction to an SEC rule change making it easier to contest elections in publicly traded companies. The board was not facing a contested election, and the stockholder-plaintiff was not planning to contest an election in the future. As a result, the plaintiff’s challenge to the bylaw was purely abstract — a so-called “facial” challenge. The plaintiff argued that provisions requiring a nominating stockholder to identify other stockholders sharing a “common goal” did so in language so expansive and loose as to impose on the nominating stockholder an unknowably vast disclosure obligation.

Applying Kellner, the Court explained that the grounds for facial challenge to an election bylaw in Delaware are very narrow. So long as the bylaw is not prohibited by some statute, or contrary to the corporation’s charter, a bylaw which can be validly applied in any circumstance survives a facial challenge and must be upheld. Since a lone stockholder nominating a preferred candidate would face very simple and limited disclosure requirements under the “common goal” provisions, the bylaw was facially valid. On a facial challenge, the court determined that it is not appropriate to consider how the bylaw might be interpreted or applied in hypothetical scenarios.

When a dissident stockholder or candidate alleges an election contest is being frustrated by an advance notice bylaw enacted or applied as unfair entrenchment by an incumbent board of directors, the Court of Chancery will examine the bylaw and its application under principles of equity. These challenges, like those presented in Kellner last year and this past May in Vejseli v. Duffy which we also wrote about, will be given a detailed and context-specific analysis of the circumstances with an eye towards ensuring fairness towards a corporation’s stockholders. By contrast, Carroll shows that abstract, facial challenges, which lack the concrete circumstances to provide that context, have only very limited availability. Additionally, Carroll emphasizes the importance of proactive diligence by a corporate board. Enacting the advance notice bylaw on a clear day before any dispute arose made the provision more resistant to challenge.

On February 17, Delaware State Senator Bryan Townsend introduced a bill, SB 21, to the state legislature.  SB 21 proposes to make significant changes to a number of sections of the Delaware General Corporation Law (DGCL).  The DGCL is the statute which provides for the creation of Delaware corporations, and governs their internal affairs.  As such, it is the governing law for about two-thirds of the Fortune 500. 

Historically, amendments to the DGCL have started as proposals in the Delaware State Bar Association (DSBA)’s  Corporation Law Section.  The DSBA is a professional organization of attorneys in Delaware, and the Section consists of corporate law specialists, including a broad spectrum of practitioners and academics.  The Delaware Constitution requires amendments to the DGCL to be enacted by 2/3 supermajorities of both chambers of the state legislature.  In practice, the DSBA and Corporation Law Section proposals have usually commanded unanimous support within the Section and DSBA, after which they have been enacted by unanimous or near-unanimous bipartisan majorities in the legislature.  While SB 21 is being sponsored by the entire bipartisan leadership of both chambers of the state legislature, as noted it was not proposed by the DSBA or the Corporation Law Section at all. Over the past year, several companies have made headlines with their proposal to move out of Delaware citing concerns resulting from recent Delaware Court of Chancery Decisions. If enacted, these amendments would significantly impact the analysis of such a decision and we would urge companies to strongly consider these amendments as part of its risk-benefit analysis if deciding whether to leave the state or stay put.

The amendments make significant changes to two sections of the DGCL, Section 144, and Section 220. 

First, the proposed amendments would significantly reduce judicial review of transactions affected by conflicts of interest.  Except for freeze-out mergers, a transaction with a corporate controller or other fiduciary would be immunized from judicial review if the transaction is approved by either a committee of the board of directors with an unconflicted majority or a vote of the unconflicted stockholders legislatively overturning last April’s In re Match Group Inc Derivative Litigation (which we covered on the blog), in which one of the parties argued that these provisions were already a part of Delaware law – an argument the Delaware Supreme Court rejected. Under current law, to cleanse a transaction with a controller requires use of both mechanisms, and the committee must be composed entirely of unconflicted directors.  

Second, the statute would codify a definition of a “controlling” stockholder or control group.  The statutory definition generally tracks existing Delaware case law on corporate controllers, except that it includes a minimum threshold of one-third of the voting stock.  Below that threshold, the proposed amendment declares that a stockholder or group is per se not a controller.  While Delaware courts are wary about finding control in a stockholder with less than 50% of the voting power, last year’s high-profile Tornetta v. Musk (which we also discussed on the blog) found the CEO to be a controller with slightly under a quarter of the company’s voting stock. 

Third, for publicly traded companies on national exchanges, the proposed amendments would heighten the presumption of independence for directors who are classified as independent by the stock exchange.  A heightened presumption of independence would make it harder for a stockholder to challenge a committee’s independence.

Fourth, for two-step tender offer mergers under Section 251(h) of the DGCL, the proposed amendment ‘deems’ tendering stockholders to be votes in favor of the transaction.  Because two-step tender offer mergers do not have a stockholder vote, this provision appears crafted to take advantage of the proposed statutory cleansing mechanisms in these types of mergers.

Fifth, the proposed amendment would modify Section 220 to greatly narrow the documents available to stockholders on a ‘books and records’ inspection.  Stockholders would generally be limited to corporate governance documents, minutes and materials of board meetings, and three years of financial statements. 

The proposed amendments have elicited a range of responses. In combination, from the perspective of corporate directors and controllers, the proposed amendments would greatly reduce litigation risk if enacted.  From the perspective of a stockholder, the proposed amendments greatly limit the rights of minority investors.  We will continue to monitor as the proposed legislation works its way through the legislature but if anything companies who are considering moving out of Delaware, or incorporating elsewhere should strongly consider the potential benefits of the proposed amendments to the DGCL.

In a corporate buyout, can the buyer be held liable for misconduct by the seller’s management? Buyer and seller sit at the opposite ends of the table — each deal team is responsible to their respective side to negotiate the best possible deal. The Delaware Supreme Court has clarified the limited circumstances in which a buyer can be held liable for misconduct by the selling company’s management, and reversed the trial court’s imposition of liability in In re Mindbody, Inc. Stockholder Litigation, Appeal No. 484, 2023 (Del. Dec. 2, 2024). Mindbody holds that an outside buyer operating at arms’ length can be held liable to the target’s stockholders only for active steps fostering fiduciary misconduct by the target’s management.

The trial court had found that a company’s founder/CEO, facing personal financial difficulties, had surreptitiously solicited a buyout from a private equity firm which he believed would keep him on as CEO. The ensuing sale process was marred by the CEO assisting the private equity firm, first by the head start and later by passing it information. This flawed process resulted in a sale price of $36.50 per share which the stockholders voted to approve, but which the trial court assessed to be $1 per share lower than the company’s management could have achieved if the sale process had been conducted properly. The trial court also found that the proxy disclosures disseminated ahead of the stockholder vote omitted or mischaracterized the CEO’s interactions with the firm, thereby concealing the sale process flaws from stockholders to gain their approval. The trial court had held that the CEO had breached his fiduciary duties in assisting the private equity firm in the sale process, and in giving misleading disclosures to the stockholders. Because the deal papers had given the private equity firm the contractual responsibility to correct inaccuracies in the proxy disclosures, the trial court also held that the private equity firm aided and abetted the CEO’s breach of his disclosure duties.

The Supreme Court fully accepted the trial court’s factual findings, and upheld its findings of liability against the company’s founder/CEO in relation to a cash-out merger. However, it held that the private equity firm did not cross the high threshold for abettor liability on the disclosure claim.

As the Supreme Court explained, aiding and abetting a breach of fiduciary duty requires the “knowing participation” of the alleged abettor. In the M&A context, the conduct and knowledge necessary to satisfy standard for liability depends on the alleged abettor’s role in the negotiations. Of all those roles (e.g. financial advisor), that of an outside, arms’-length bidder is most resistant to abettor liability. An outside bidder is supposed to try to negotiate the lowest price possible, and its deal team generally owes a fiduciary duty to its own investors to do so. As a result, only a bidder who “attempts to create or exploit a conflict of interest” on the target company’s board can be held liable, a standard which requires “active participation rather than ‘passive awareness.'”

The Supreme Court drew a line between sins of commission and omission. The proxy disclosures were misleading because the selling company’s fiduciaries wrote them that way, already aware that they were misleading. The buying firm did not draft any of the misleading disclosures, nor did it in any way deceive the fiduciaries at the company who did (either by active steps or silence). Their contractual duty to correct inaccuracies would have been satisfied by informing the company’s management of the truth, but it was a truth management already knew. The Supreme Court held that the firm’s contractual duty to the company did not extend to a fiduciary duty to the company’s stockholders directly. Without more, the Supreme Court found this insufficient to support an outside buyer’s abettor liability.

Notably, the plaintiffs did not plead abettor liability for the CEO’s sale process violations — only for the misleading disclosures. The Supreme Court took care to note that it, like the trial court, was not passing judgment on whether the buying firm’s interactions with the CEO in the sale process — taking advantage of the head start, and taking advantage of the information the CEO passed along during negotiations — constituted “active participation” in exploiting the CEO’s conflict of interest.

When a buyer seeks to acquire a target company, Delaware law permits it wide latitude to pursue a deal on the most advantageous terms possible. Its privilege to do so stops only at taking active steps to create or exploits conflicts of interest between the target’s management and stockholders. Passivity and silence in the face of a knowing disclosure violation by the target’s management, at least in this case, were not enough to impose liability. See Arthur Clough, The Latest Decalogue (1862) (“Bear not false witness; let the lie//Have time on its own wings to fly.”)

Do you own shares of stock? Are the stock certificates in a dusty bank box somewhere? Have you received communications from the company recently? If not, you should probably check in with the company to see if your shares have been escheated to the state. Please see here my recent article in the Delaware Business Court Insider discussing a recent Delaware opinion on the matter.