Duane Morris Delaware Business Law

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.

One of the hallmarks of contract law is that it is not fault-based.  A court, and especially a ‘contractarian’ Delaware court, only looks at whether a party performed the duties the contract imposes, not why.  If parties want to be able to excuse performance for the ‘right’ reasons, or to trigger extra protections against breach for the ‘wrong’ reasons – that is, if they want to depart from the default no-fault analysis – then they need to write those reasons into the contract language itself.  In the recent XRI Investment Holdings, LLC v. Holifield decision, the Court of Chancery examined a contract that did just that, containing provisions triggered by a finding of “willful breach,” but left that term undefined.  Thus, the Court had to answer the question: what is a “willful breach” of contract?

In XRI, an LLC’s operating agreement required the LLC to advance legal fees to its members for LLC-related litigation, but allowed the LLC to recoup those fees if the litigation found the member had acted with “gross negligence or willful breach” of the LLC operating agreement. In the litigation, the LLC sued a member to challenge the putative transfer of the member’s membership interest in the LLC to an entity he controlled.  In accordance with the agreement, the LLC advanced the member’s legal fees to defend against the LLC’s suit against him.  The LLC prevailed in a 2022 decision that found the transfer breached the LLC’s operating agreement and was void, a finding the Delaware Supreme Court affirmed in an opinion last year.  In these post-remand proceedings, the LLC sought to recoup those previously-advanced legal fees under the argument that the member’s attempt to transfer his membership interest had “willfully breached” the LLC operating agreement.

As the Court explained, clauses specifying remedies for “willful” breach are common in commercial contracts, especially in merger agreements, but more often than not, the commercial contracts themselves do not supply a definition of “willful breach.”  In addition, despite the frequency of undefined “willful breach” clauses, no prior Delaware decision provided a default definition.    Scholarly sources the Court examined suggest three different possible measures of when a breach of contract becomes ‘willful.’

Under the most expansive standard, a breach is ‘willful’ if the breaching party simply did the breaching act on purpose.  A middle definition further requires the breaching party to subjectively understand at the time that the act violated the contract.  A narrow definition requires a further showing that the breaching party acted with malice.

The XRI decision does not identify a one-size-fits-all definition of willful breach.  But in evaluating the facts of this case, since “willful breach” followed “gross negligence” in the same sentence of the operating agreement, the Court construed such placement as embodying a meaning that goes beyond mere voluntary action, in line with the middle definition.  At least in the context of “gross negligence and willful breach,” conduct must be undertaken in subjective cognizance that it is a breach in order to be “willful.”  Since the Court also found that the member had known the LLC operating agreement prohibited the transfer and did it anyway, the court held that the breach was willful under that standard and ordered the member to repay the LLC for his litigation costs, which were in the millions.

The Court’s decision has consequences well beyond the relatively niche world of advancement-recoupment actions.  Because protections against “willful breach” occur so frequently in merger agreements without a contractual definition of the term (in the decision, the Court noted that in a study of over 1,000 merger and acquisition agreements while “a majority tie damages to a concept of willful breach, less than one third of public deals, and under one tenth of private deals, define the term”), the default rules supplied by Delaware case law may prove significant in cases involving mergers and acquisitions, which are among the marquee subject areas of Delaware litigation.

Moreover, recent amendments to the Delaware General Corporate Law (“DGCL”), which we have previously discussed outside this blog, have added an additional dimension of importance.  As previously discussed, the amendments authorize the inclusion of corporate governance provisions in stockholder agreements, but the outer bounds of inclusion of such provisions remains unknown.  The DGCL amendments have already set off a flurry of discussion among practitioners and scholars over what happens when such a stockholder agreement requires a corporate fiduciary to act one way while their fiduciary duties command the opposite.  If a fiduciary, in the face of such contradictory duties, prioritizes the fiduciary duty over the contractual one, is that breach “willful”?  With the court’s answer to that question unknown, parties may want to consider addressing it themselves through an express provision in the contract for added clarity.

Finally, with “willful breach” terms so common in the context of mergers & acquisitions agreements, XRI v. Holifield demonstrates the prudence of parties setting out an express definition within the body of their agreements to ensure the parties have clarity on its meaning.

Last week, the Delaware Supreme Court handed down a decision in Kellner v. AIM  Immunotech, Inc., partially reversing a decision from the Court of Chancery this past December.  The opinion gives color to an important topic in Delaware corporate law: when a corporate board adopts bylaws into the corporation’s constitutive contract which are valid in the abstract, but does so in an inequitable manner, how should a court remedy the unfairness?   

Kellner related to a long-running effort by a group of dissident stockholders to get allies elected to the corporation’s board.  In this latest litigation, the stockholders challenged recently-enacted corporate bylaws which the incumbent board used to block their nomination of candidates.

As we have previously discussed on this blog in relation to the Coster v. UIP Companies case last year, Delaware courts describe fiduciary conduct as “twice-tested,”  first for legal authority, and second for equity.

For legal authority, the Court found that all but one of the bylaws passed.  Each was directed to important goals of disclosure and transparency in corporate elections.  Had they been enacted on a clear day — meaning, in the absence of a dissident group of stockholders trying to unseat the incumbent board — there was nothing wrong with them.  But, at the second step, deferring to the trial court’s factual findings, the Court found that the board had crafted the bylaws for the improper purpose of de facto preventing stockholders from voting in a contested election at all.

The Court explains the correct remedy following from that structure of analysis: the bylaws were successfully adopted and incorporated into the corporate contract, but should not have been applied to the dissidents in the specific election at issue.

With the recent amendments to the Delaware General Corporate Law permitting internal corporate affairs ordinarily contained in the corporate constitutive contract — the charter and bylaws —  to be addressed by stockholders’ agreements, this framework of analysis may see frequent use in the coming years.