Supreme Court Clarifies Treatment of Valid But Unfair Corporate Rules

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.


Weinberg Center for Corporate Governance holds its 2024 Distinguished Speaker and Panel

The John L. Weinberg Center for Corporate Governance of the University of Delaware recently put on a great program with two very timely and important presentations. One on how companies and their boards can navigate the turbulent waters surrounding calls for the entity to speak out on cultural and other “hot button” topics–some of which may be directly related to the business of that entity–some not. And second, a very lively panel discussion of the modern day use of special litigation committees to review derivative claims and litigation. Links to videos and other materials from this fantastic presentation may be accessed here.

How Do the New Texas Business Courts Stack up to Delaware’s Court of Chancery?

There has been much in the news recently about whether Delaware’s preeminence in the world of corporations and alternative entities is being materially challenged by other states–such as Texas or Nevada.  Recently, Texas armed its challenge with the passing of legislation creating a new system of business courts designed to better address the needs of sophisticated, commercial litigants.

The Spring 2024 edition of The Advocate, the journal of the Litigation Section of the Texas Bar Association, contains a series of articles on many aspects of the new Texas business courts, including support for and challenges facing that legislation and the courts it created.  My colleague (Mackenzie Wrobel) and I contributed an article titled: “Lessons Learned: What Can the New Texas Business Courts Learn from the Experience of Its Sister States.?”  In that article we discuss how states such as Delaware, North Carolina, Georgia and Wyoming have approached the tasks of creating business courts that foster the stability and predictability that sophisticated commercial litigants seek in submitting their disputes to such tribunals.

It will be interesting to watch how Texas navigates the same ground as some of her sister states.  Stay tuned.


Delaware Supreme Court Gives Additional Guidance on Scope and Mechanics for Applying MFW Framework to Conflict Transactions

Recently, the Delaware Supreme Court issued its much-anticipated decision in In re Match Group, Inc. Derivative Litigation, No. 368, 2022 (April 4, 2024), in which the Court reaffirmed certain venerable teachings on the standards of review that the Delaware courts will employ to review challenged transactions involving a controlling stockholder—including when and how controlling stockholders can deploy the “MFW framework” (from Kahn v. M&F Worldwide Corp, 88 A.3d 635 (Del. 2014) (“MFW”)) to shift the standard of review from “entire fairness” to “business judgement.”  In general, the MFW framework reflects the Supreme Court’s ruling in that case that where a controlling stockholder conditions a going-private transaction (which would normally be reviewed under the exacting entire fairness standard), from the beginning, on (1) approval by a fully-functioning independent committee of directors and (2) a fully-informed vote of the unaffiliated minority stockholders, the Delaware courts will look to see if that transaction was within the business judgment of the fiduciaries presenting and approving it.

Since the ruling in MFW in 2014, transactional planners, stockholder plaintiffs, and corporate defendants have all probed the contours of the ruling in various ways.  For instance, can the MFW framework be deployed outside a squeeze-out merger context or does the entirety of the special committee need to be independent and disinterested or can just a majority of the members of the committee be satisfactory?

In the Match opinion, the Supreme Court discusses in detail (1) the historical framework of the various standards of review that the Delaware courts will use to review challenged corporate transactions and conduct, (2) the history behind, and the nature of, the Court’s ruling in MFW, and (3) additional guidance for corporate constituencies (including controlling stockholders, boards of directors, and their advisors) on the scope of and mechanics for properly deploying the MFW framework to shift the standard of review from entire fairness to business judgment.  Specifically, the Supreme Court held:

  • Long-standing precedent holds that “in a suit claiming a controlling stockholder stood on both sides of a transaction with the controlled corporation and received a non-ratable benefit, entire fairness is the presumptive standard of review”—this is not limited to going-private mergers, but rather applies to all transactions with a controlling stockholder that would historically have been reviewed for entire fairness.
  • A “controlling stockholder can shift the burden of proof [to prove the transaction was not entirely fair] to the plaintiff by properly employing a special committee or an unaffiliated stockholder vote” (emphasis added).  However, “the use of just one of these procedural devices does not change the standard of review” from entire fairness to business judgment.
  • If “the controlling stockholder wants to secure the benefits of business judgment review, it must follow all [of] MFW’s requirements.”  That is, the transaction must be conditioned on both the approval by an effective and independent special committee, and the informed vote of approval by the unaffiliated stockholders.
  • For the special committee to be effective in “replicat[ing] arm’s length bargaining, all [special] committee members must be independent of the controlling stockholder.”



And . . . Yet Another Minute About Minutes

Over the years we have used this blog to highlight Delaware case law where the topic of corporate minutes has played a material role in the way the court has reviewed the actions of a board of directors.  Those posts can be found here under the tag “minutes.”

Recently, The Honorable Leo E. Strine, Jr. (Ret.), the former Chief Justice and Chancellor of Delaware, posted a short summary on the Harvard Law School Forum on Corporate Governance of a more comprehensive paper he has written on this topic titled: “Minutes are Worth the Minutes: Good Documentation Practices Improve Board Deliberations and Reduce Regulatory and Litigation Risk”  forthcoming in the Fordham Journal of Corporate and Financial Law.  

Spending some time reading Chief Justice Strine’s article is well-“Worth the Minutes” invested, as he has done a great job of surveying the case law and highlighting the methods and means for generating corporate minutes that will most likely withstand scrutiny and give confidence to the court in the governance actions taken at such meetings.

A Searching Obligation of Disclosure Must Be Satisfied to Obtain MFW Deal Protection

On Monday in City of Dearborn Police and Fire Revised Retirement System (Chapter 23) v. Brookfield Asset Management Inc., the Delaware Supreme Court reversed the Court of Chancery in a case challenging a squeeze-out merger.  The Court of Chancery had dismissed on the basis of the MFW cleansing, ruling that an effective special committee and informed, disinterested stockholder vote had neutralized the conflict of interest in the controller-led buyout.  But, the Supreme Court held that deficient disclosures in the proxy material surrounding conflicts of interest affecting the financial and legal advisors to the special committee impaired the stockholder vote, even though those conflicts were not themselves sufficiently serious as to constitute a breach of duty.

As we have discussed before, under the “business judgment rule” while Delaware courts do not second-guess corporate boards’ actions in most cases, that deference does not apply when a corporate board, or someone upon whom they are beholden, has a conflict of interest.  One of the most important types of these conflicted transactions are ‘squeeze-outs,’ i.e. transactions in which a controlling stockholder seeks to buy out the minority stockholders.  Because of the conflict of interest this creates, Delaware courts review these transactions under the searching “entire fairness” standard of review.  Delaware does, however, provide a mechanism for controllers interested in pursuing a squeeze-out to do so without losing the protection of the business judgment rule.  This mechanism, called MFW cleansing, requires the controller to first set up an independent special committee to negotiate the transaction, and to condition the transaction on the fully-informed approval of the minority stockholders.  If the special committee independently negotiates the transaction, and if the minority stockholders approve it, Delaware law regards this as effectively neutralizing the conflict of interest and will apply the business judgment rule, resulting in a pleading-stage dismissal of a lawsuit challenging the transaction.

But, if a plaintiff demonstrates that either of these procedural protections were flawed – that the special committee could not or did not perform its function of properly mimicking an independent board, or if the vote of the minority stockholders was not fully informed – then the business judgment rule does not apply and a court will review the transaction under the entire fairness standard.

City of Dearborn concerns just such a freeze-out merger transaction.  A company owning 62% of the stock in a publicly-traded company proposed to buy out the minority stockholders.  The controller set up a special committee, which hired its own advisors and negotiated, eventually agreeing to a transaction that valued the company at $3.3 billion.  The special committee recommended the board approve the transaction, which it did, after which the company prepared a proxy statement to be sent to investors.

The plaintiff stockholders sued.  The stockholders argued that the special committee could not act independently because of improper threats by the controlling company; or, in the alternative, that it failed to do so by improperly relying on legal and financial advisors whose relationships were too close to the controlling company.  It also argued that the stockholder vote was uninformed, because of a number of things which they allege the company omitted or misstated in the proxy materials.  The trial court disagreed and held both MFW protections were satisfied, and dismissed the case under the business judgment rule.  The stockholders appealed and, on Monday, the Supreme Court reversed.

On this appeal, the Supreme Court agreed with the trial court that the special committee had functioned properly and was not coerced, but disagreed that the stockholder vote had been fully informed.  In particular, it held that three pieces of information were missing or incorrectly described in the proxy materials, fatally undermining the disclosures.  First, it characterized the proxy materials as failing to disclose that the special committee’s financial advisor had a $470 million stake in the controlling company and its affiliates; second, as failing to disclose the special committee’s legal advisor had both prior and ongoing representations of the controlling company; and third, as failing to adequately disclose the benefits the controlling company would reap from consolidation.

The Supreme Court held that, although the financial and legal advisors’ relationships with the controller were not sufficiently close to make it wrongful for the special committee to retain them, the duty of disclosure is broader and requires candor about an advisor’s conflicts which are not themselves disabling. Additionally, a description of the benefits from consolidation needed to be “clear and transparent.”  The company’s disclosures fell short with respect to a change in management fees, which would net $130 million per year, as it disclosed only a formula, and significant additional research and work would have been necessary for a stockholder to replicate that calculation.

As a result of those deficiencies, the case was remanded back to the trial court, which will now – after discovery and trial – examine the transaction for its entire fairness.  The directors may still prevail – with the operation of the special committee and the $3.3 billion price tag, the Court of Chancery may still hold that the transaction was ‘entirely fair.’  But, even if it does, the discovery and trial process may be expensive and time-consuming, emphasizing the importance of scrupulously adhering to the MFW framework in order to obtain pleading-stage dismissal.

Directors Must Exercise Independent Business Judgment or Risk Losing Business Judgment Rule’s Protection

Much ink will be spilled in the circles of corporate law about Chancellor McCormick’s blockbuster opinion in Tornetta v. Musk, C.A. No. 2018-0408-KSJM (Del. Ch. Jan. 31, 2023), in which the Court invalidated a CEO’s executive compensation package worth $55 billion.  A full discussion of the over-200-page opinion is beyond the scope of this blog, but one key takeaway for our readers may be this simple maxim: to preserve judicial deference to a corporate board’s independent business judgment, corporate directors need to actually exercise their independent business judgment.

Corporate directors are presumed to be independent, and therefore ordinarily a decision on how to compensate the CEO or other corporate officers is a matter for their business judgment which usually will not be second-guessed by a reviewing court.  When, however, directors act on a matter for which they either have a conflicting interest, or for which they are facially disinterested but cannot or did not act independently, the courts of Delaware review the transaction under the “entire fairness” standard.  Under “entire fairness,” both the transaction process and the transaction terms are examined by the court, holistically and searchingly, for their intrinsic fairness to the entity and the stockholders.  Before reaching the question of whether the transaction was entirely fair, the Chancellor therefore addressed the question of whether entire fairness review was appropriate in the first place.

At the time the compensation package was proposed and negotiated, the CEO owned slightly more than one-fifth of the company’s equity and voting power.  That made him an extremely influential stockholder, but not a completely dominant one — at least, not on paper.  He lacked the power to elect or remove corporate directors unilaterally, for example.

Instead, what was decisive for the Chancellor was the behavior of other corporate directors and officers in the compensation transaction itself, all of whom she found to have treated the CEO as the key decision-maker.  The CEO proposed the structure and size of his compensation package, and the other board members and corporate officers, rather than engage in adversarial negotiation, or consider alternatives,  engaged in a “cooperative and collaborative process” to make the CEO’s proposal a reality.  As a result, instead of the Board of Directors negotiating with the CEO at arm’s length on the nature and dimensions of his compensation package, she found the CEO was essentially deciding on his own compensation, i.e. acting as a self-interested controller, with the attendant application of entire fairness.

Examining the process of the transaction is, as noted above, a part of entire fairness review.  But Tornetta shows that a sufficiently poor process can itself  be a major factor prompting the Court to conduct entire fairness review in the first place.  That is, if directors conduct themselves with a ‘controlled mindset,’ that appearance can itself be evidence that facially-disinterested directors are beholden to the one to whom they are deferring, and vitiate the protections of the business judgment rule.

Delaware courts give great deference to corporate directors and other fiduciaries when they exercise their own independent judgment.  But, they place that deference at risk if they surrender that judgment to someone else, like a “superstar CEO.”  Thus it remains critical that corporate fiduciaries remember to apply their own judgment to decide what is in the company’s best interests, and to articulate their reasons for why they are thinking and acting the way they are.  And, of course, as has been mentioned on this blog before, ideally they should remember to accurately and timely document their actions and reasoning in the minutes.

Circle of Trust: When can a Corporate Director Share Confidential Documents with a Stockholder-Plaintiff?

Stockholders who suspect mismanagement or other fiduciary misconduct generally begin by investigating via a books-and-records demand in order to articulate the allegations for the complaint in a so-called “plenary” action.   But, what happens if the stockholders have allies on the board itself?  In Icahn Partners LP et al. v. Francis deSouza et al., C.A. No. 2023-1045-PAF (Del. Ch. Jan. 17, 2024), the Court holds that directors cannot pass confidential or privileged material to their stockholder allies, and those allies cannot incorporate the improperly acquired material, unless there is a special relationship between the director and stockholder such that they constructive share “one brain.”  Because the director here did not have such a relationship, the sharing was improper, and the pertinent portions of the stockholders’ Complaint were stricken.

In Icahn Partners, a parent spun off a subsidiary which raised money and then held an IPO.  Post-IPO, the two companies agreed to a transaction by which the parent would re-acquire the subsidiary.  European regulators issued a standstill order, which the companies disregarded, consummating the merger instead.  European regulators issued a final ruling barring the merger, ordering divestiture, and levying nearly a half-billion euro fine for violation of the standstill order.  Contemporaneously, entities affiliated with investor Carl Icahn owning approximately 1.4% of the company’s stock sponsored a slate of candidates for the parent’s board.  One candidate prevailed and was seated.  He was an employee of a different, non-stockholding Icahn affiliate.  The new director signed on to confidentiality agreements pertaining to the secrecy of certain corporate documents and information.  That new director used his position on the parent’s board to furnish confidential materials to the stockholding Icahn entities.  The entities incorporated the material a complaint alleging breach of fiduciary duty against  the parent’s other directors.  The defendants moved to strike parts of the (under seal) complaint  which made use of those confidential materials.

The Court walked through a decades-long history of cases which create two categories of special relationships between directors and stockholders in which the director can share confidential material with the affiliated stockholder:

(1) the director is designated to the board by the stockholder pursuant to contract or the stockholder’s voting power; or (2) if the director also serves in a controlling or fiduciary capacity with the stockholder.

Outside of those categories, the Court held such sharing was improper, and that the appropriate remedy was to strike the corresponding portions of the complaint.

Here, the director was elected at-large by the stockholders generally, and so  his means of ascend did not create a special relationship under the first arm.  Nor did his outside relationship to the stockholder-plaintiffs make him a co-fiduciary, failing the second arm.  Instead, he was an employee of an affiliate.  Thus, the Court held the director should not have shared the material and granted the corresponding motion to strike.

This might strike a reader at first glance as a somewhat counterintuitive result.  If a director who is beholden to a sponsoring stockholder can share documents with that stockholder in order to prosecute a corporate injury, why is that power denied to a director who has that ally and the support of a broader constituency?  As the Court explained, the underpinnings of the special relationship theory is that the stockholder and the director share “one brain,” such that the stockholder is in some sense constructively on the Board.  Where the constituency supporting the insurgent director is broader, and where the director’s relationship with the key stockholder-ally is remote, that one-brain alignment is absent.  A major stockholder needs to sponsor a sufficiently high-level fiduciary to bring itself fully into the circle of trust — and, as the Court observes, that closeness then operates in both directions, potentially constraining the stockholder’s ability to buy and sell shares of the company.

So, the key points are:

  • A director or board minority cannot breach the confidences of the corporation and board in order to act as a whistleblower/informant to an allied stockholders, absent a special relationship with the stockholder.
  • A special relationship exists if the stockholder gets to unilaterally select the director — such as a controller, or a special series or class of stock, or via a stockholders’ agreement.
  • A special relationship also exists if the director is a co-fiduciary  of the stockholder.

Stockholders running insurgent director slates on the belief that an incumbent board may be in breach of its duties should bear these requirements in mind.  If an insurgent slate cannot actually win control of the board, then the stockholder needs for its sponsored directors to be so close into its own confidence as to bring itself within the board’s circle of trust — with all the attendant obligations from that closeness — in order to make use of the director’s document access in investigating those suspected breaches.  Failing that, the stockholders must to rely on the more limited inspection rights available to stockholders under DGCL Section 220.

Conversely, Icahn gives guidelines to corporate boards for fending off partially-successful insurgent slates sponsored by major stockholders.  By setting up strong confidentiality rules and agreements for directors, it forces those stockholders to make a choice — in or out.

Chancery Acknowledges Non-Competes Treated More Skeptically in Recent Decisions

The case Sunder Energy, LLC v. Jackson, C.A. No. 2023-0988-JTL relates to non-compete covenants contained in an LLC operating agreement.   In November, the Court of Chancery denied a preliminary injunction enforcing the covenants.    In Delaware, appeals to the Supreme Court are as-of-right, but only when a case is fully decided — a party appealing a preliminary injunction denial is almost always told to wait, unless the trial court “certifies” an immediate appeal.  The Sunder Energy plaintiff asked the trial court to do just that, and late last month, Vice Chancellor Laster took the rare step of granting certification.

In his 35-page opinion explaining why he was certifying the appeal, the Vice Chancellor addressed, among other points, the plaintiff’s argument that “over the past few years, there has been a growing trend that disfavors restrictive covenant litigation in the Court of Chancery.”

That recent trend has been visible on this blog — last year, we discussed a case where the Court refused to apply Delaware law despite a contractual choice-of-law clause in a covenant when the covenant was contrary to fundamental policy of the state of employment, and another where the Court refused to ‘blue pencil’  an overly-broad covenant into a narrower, more reasonable one.

The Vice Chancellor acknowledged that the plaintiff’s “impression is not unfounded,” and agreed that the decisions of the last decade have shown greater skepticism towards non-compete covenants than the older cases, though reckoning the difference as only “a matter of degree.”  While explaining that the trend against covenants was not itself a a major factor in his decision to certify immediate appeal, the Vice Chancellor agreed that the Delaware Supreme Court’s review would be important and clarifying.

The Delaware Supreme Court gives ‘great weight’ to a trial court’s certification for an immediate appeal, and is often attentive to questions the trial court specifically identifies as needing the higher court’s guidance.  Sunder Energy is likely to give us the authoritative word on non-competes in Delaware.  Watch this space — we will keep you informed on the Supreme Court’s decision whether to accept the immediate appeal, and of any subsequent decision.


Duty of Oversight of Officers–Post-McDonald’s Action in Court of Chancery

Nearly one year ago we reported in this blog on the Court of Chancery’s decision in In re McDonald’s Corp. S’holder Litigation, 289 A.3d 343 (Del. Ch. 2023), in which the court affirmatively held that officers of Delaware corporations owe duties of oversight (often called, Caremark duties), and specifically for matters that would fall within their managerial purview.  In a recent decision granting a motion to dismiss in Segway Inc. v. Hong Cai a/k/a Judy Cai, C.A. No. 2022-1110-LWW (Del. Ch. Dec. 14, 2023), Vice Chancellor Will has provided practitioners counselling corporate officers with additional guidance on how the Court of Chancery will apply the duty of oversight to officers (as opposed to directors)—particularly when reviewing the sufficiency of claims pled against such officers.

This decision makes clear that “[d]espite a proliferation of modern jurisprudence, bad faith remains a necessary predicate to any Caremark claim.”  This is so no matter whether the fiduciary whose conduct is challenged is an officer or a director.  While the McDonald’s decision “emphasized that—barring extreme facts—an officer’s duty of oversight would only extend to matters within the officer’s remit,” that decision did not “craft a lower standard for oversight claims brought against officers.”  Because the complaint in this case did not sufficiently plead  “potential wrongdoing (much less within [the officer’s] purview),” the Vice Chancellor dismissed the claims.

In closing the Memorandum Opinion, Vice Chancellor Will summarized the current state of the law as it pertains to the Caremark duties owed by officers of Delaware corporations as follows:

The Caremark doctrine is not a tool to hold fiduciaries liable for everyday business problems.  Rather, it is intended to address the extraordinary case where fiduciaries’ “utter failure” to implement an effective compliance system or “conscious disregard” of the law gives rise to a corporate trauma.  These tenets of our law persist regardless of whether a Caremark claim is brought against a director or an officer.  Officers’ management of day-to-day matters does not make them guarantors of negative outcomes from imperfect business decisions.

* * *

At a minimum, a plaintiff pursuing an oversight claim against an officer would need to demonstrate that the officer failed to make a good faith effort to monitor central compliance risks within her remit that pose potential harm to the company or others.

To the extent officers of Delaware corporations or their advisors might have read the earlier McDonald’s decision as creating an easier path to liability for duty of oversight claims for officers as opposed to directors, this recent decision should quiet those concerns.

© 2009- Duane Morris LLP. Duane Morris is a registered service mark of Duane Morris LLP.

The opinions expressed on this blog are those of the author and are not to be construed as legal advice.

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