Duane Morris Delaware Business Law

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.

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.

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.”

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.