Duane Morris Delaware Business Law

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.

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.

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.

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.

 

In late June, the Delaware Supreme Court issued in its decision in the second appeal of Coster v. UIP Companies, 2023 WL 4239581 (Del. June 28, 2023). As with their prior decision (255 A.3d 952 (Del. 2021)), the Court was reviewing a judgment in favor of the defendants on a challenge to the decision by an incumbent board of a 50/50 deadlocked corporation to sell shares to a longtime employee.  In the first round, the Court of Chancery held that the challenged transaction satisfied the ‘entire fairness’ test, and so upheld it.  On the first appeal, the Supreme Court found that analysis incomplete, reasoning that fiduciary conduct in Delaware is “‘twice-tested,’ first for legal authorization, and second for equity.”  Entire fairness meant the transaction was legally authorized, but because additional considerations of equity were implicated the Court remanded for the Chancellor to conduct further “Schnell/Blasius” analysis in the first instance.  On remand, the Chancellor found the transaction was equitable under the circumstances, and this time the Supreme Court upheld it in an extensive opinion discussing the interplay of three long-standing, landmark Delaware decisions — Schnell v. Chris Craft Industries, Inc., 285 A.2d 437 (Del. 1971), Blasius Industries, Inc. v. Atlas Corp., 564 A.2d 651 (Del. 1988), and Unocal Corp. v. Mesa Petroleum Co., 493 A.2d 946, 955 (Del. 1985).

Unocal is the hornbook case for anti-takeover measures.  It is constantly cited in cases addressing challenges to board action when the directors have sought to prevent a hostile takeover.  In what is sure to be an oft-quoted passage from Coster, the Supreme Court reasoned:

Unocal can also be applied with the sensitivity Blasius review brings to protect the fundamental interests at stake – the free exercise of the stockholder vote as an essential element of corporate democracy.

The recent decision Berger v. Adkins, 2023 WL 5162408 (Del. Ch. Aug. 8, 2023)  gives some color to how the Court of Chancery understands Coster to operate.  In Berger, a company received a capital infusion by selling a new series of preferred stock to a group of investors.  The preferred stock could not vote, but was convertible to common stock, and could vote on an as-converted basis for change-of-control transactions.  If converted, the preferred stock was 48% of the overall voting power of the corporation.  As part of the infusion transaction, the investors agreed to standstill agreements which barred them from certain kinds of stockholder activism, such as soliciting proxies, for a specified time.  A stockholder sued, reasoning that the board members’ own stock ownership combined with the preferred as-converted vote to constitute an outright majority, which in combination with the standstill agreements put the board in control of the corporation and effectively made the capital infusion a takeover that stripped the existing stockholders of their voting rights.  After litigation began, the board waived the standstill agreements and the plaintiff dismissed the complaint and filed a mootness fee petition, which the Berger decision addressed.

In the Court’s evaluation of the merits of the original complaint for purposes of determining the appropriateness of a mootness fee, Chancellor McCormick summarized the Coster rule in a single sentence:

Following Coster, this decision treats Blasius as a context-specific variant of Unocal.

Delaware permits the directors of a corporation broad authority to manage a corporation, while cordoning off stockholder authority to a few areas.  Though the province of authority reserved to the stockholders is small, it is mighty — numerous Delaware cases have disallowed intrusions upon it while rhetorically extolling stockholder supremacy within it as the normative foundation of “corporate democracy.”

Per Berger, the Court of Chancery reads Coster for the proposition that Unocal is the single framework for evaluating the board’s action when they seek to use their powers to intrude on the stockholders’ domain.  In traditional Unocal analysis, the intrusion anticipates a new contender acquiring stock and exercising its powers in a way contrary to the incumbent board’s plans.  The Coster situation is implicated when the putative interferer is already a stockholder whose interference consists of exercising their rights as stockholders.  The fiduciary duty to treat stockholders equitably therefore requires greater ‘sensitivity.’  In other words, Coster makes Unocal analysis more searching when the call is coming from inside the house.

This framework brings an elegant simplicity to an area of analysis that, because it lies at the intersection of several key doctrines of Delaware corporate jurisprudence, has previously been difficult to analyze.  Going forward, corporate boards have clear guidance on how their actions will be evaluated.  From a practical standpoint, if the board is worried that the actions of existing stockholders might interfere with the board’s business plans for the company, they need to reckon with that possibility head-on.  Stockholder authority is not something to be lightly sidestepped.  If the Board decides to proceed in a manner designed or intended to neutralize stockholder opposition or power in order to achieve a corporate objective, they must deliberate on why such action is necessary, weigh possible alternatives, and choose a means of securing the corporate objective that interferes as minimally as possible with the stockholders’ voice.  Proceeding in that way best-positions the directors to withstand the scrutiny the Court articulated in Coster:

First, the court should review whether the board faced a threat to an important corporate interest or to the achievement of a significant corporate benefit.  The threat must be real and not pretextual, and the board’s motivations must be proper and not selfish or disloyal. As Chancellor Allen stated long ago, the threat cannot be justified on the grounds that the board knows what is in the best interests of the stockholders.

Second, the court should review whether the board’s response to the threat was reasonable in relation to the threat posed and was not preclusive or coercive to the stockholder franchise. To guard against unwarranted interference with corporate elections or stockholder votes in contests for corporate control, a board that is properly motivated and has identified a legitimate threat must tailor its response to only what is necessary to counter the threat. The board’s response to the threat cannot deprive the stockholders of a vote or coerce the stockholders to vote a particular way.

We wrote about Vice Chancellor Laster’s decision in New Enterprise Associates 14, L.P. v. Rich, C.A. No. 2022-0406-JTL a few weeks ago.  For a more comprehensive discussion of this landmark decision, please find a full Alert on the Duane Morris website.

The Court of Chancery on Tuesday held that stockholders’ covenants not to sue for breach of fiduciary duty are enforceable subject to public policy limitations in New Enterprise Associates 14, L.P. v. Rich, C.A. 2022-0406-JTL.  Conducting a deep-dive into the history and philosophical underpinnings of fiduciary law, the Court reasoned that specific, limited, and reasonable covenants not to sue are valid, but that Delaware abhors pre-dispute waivers of suit for intentional harms.  The Court laid out a two-part test, sure to join the corporate practitioner’s lexicon of eponymous capital-t Tests swiftly:

First, the provision must be narrowly tailored to address a specific transaction that otherwise would constitute a breach of fiduciary duty.  The level of specificity must compare favorably with what would pass muster for advance authorization in a trust or agency agreement, advance renunciation of a corporate opportunity under Section 122(17), or advance ratification of an interested transaction like self-interested director compensation.  If the provision is not sufficiently specific, then it is facially invalid.

. . .

Next, the provision must survive close scrutiny for reasonableness. In this case, many of the non-exclusive factors suggested in Manti point to the provision being reasonable. Those factors include (i) a written contract formed through actual consent, (ii) a clear provision, (iii) knowledgeable stockholders who understood the provision’s implications, (iv) the Funds’ ability to reject the provision, and (v) the presence of bargained-for consideration.

Finding the covenant at issue passed the test, the Court held the covenant enforceable subject to Delaware’s policy against exculpating intentional harms.  To invoke that policy, and thereby avoid the covenant and obtain damages, a plaintiff must plead and prove that the fiduciaries acted in a manner contrary to the company’s best interest in “bad faith,” a more stringent standard than even recklessness.

Critical to the Court’s analysis was the anti-suit covenant’s placement in a stockholder-level agreement.  As the Court explained in an over-1200-word footnote discussing different conceptions of the fundamental nature of the corporate form, the covenant’s contractual placement means it merely “addresses a stockholder right appurtenant to the shares that the Funds owned as their private property” without raising the logical, practical, and normative difficulties arising from placement in the corporation’s constitutive documents, i.e. the bylaws or charter.