The Corwin Effect: Stockholder Approval of M&A Transactions

Steven M. Haas is a partner at Hunton & Williams LLP. This post is based on a Hunton & Williams publication by Mr. Haas, and is part of the Delaware law series; links to other posts in the series are available here.

The most important development in Delaware law during 2016 was arguably the courts’ growing deference to stockholder approval. In 2015, the Delaware Supreme Court held in Corwin v. KKR Financial Holdings that a transaction subject to enhanced scrutiny under Revlon will instead be reviewed under the deferential business judgment rule after it has been approved by a majority of fully informed and uncoerced stockholders. During 2016, several Delaware courts applied Corwin with important consequences. Among other things, Delaware judges held that the business judgment rule becomes “irrebuttable” if invoked as a result of a stockholder vote; Corwin is not limited to one-step mergers and thus also applies where a majority of shares tender into a two-step transaction; the ability of plaintiffs to pursue a “waste” claim is exceedingly difficult; and if directors are protected under Corwin, aiding and abetting claims against their advisors will be dismissed too.

The Corwin Decision

In Corwin, the Delaware Supreme Court affirmed the dismissal of an equityholder’s challenge to a merger. The Supreme Court held that a merger is reviewable under the business judgment rule after it is approved by uncoerced, fully informed, and disinterested holders of a majority of the corporation’s shares. The Supreme Court also said its holding applied to change of control transactions, which are initially subject to enhanced judicial scrutiny under Revlon. It explained that “Unocal and Revlon are primarily designed to give stockholders and the Court of Chancery the tool of injunctive relief to address important M&A decisions in real time, before closing. They were not tools designed with post-closing money damages claims in mind, the standards they articulate do not match the gross negligence standard for director due care liability under Van Gorkom, and with the prevalence of exculpatory charter provisions, due care liability is rarely even available.” Thus, a transaction subject to enhanced scrutiny under Revlon before a stockholder vote is, under Corwin, protected by the business judgment rule after the stockholder vote.

Traditionally, once the business judgment rule applies, a plaintiff is relegated to proving that the transaction constituted a “waste” of corporate assets. The Supreme Court, however, did not explain whether the business judgment rule, after being invoked by a stockholder vote, could still be rebutted by allegations of breach of fiduciary duty. If it could be rebutted, the protections under Corwin might have been of limited utility. As discussed below, subsequent Court of Chancery decisions have addressed this issue and concluded that a fully informed and uncoerced stockholder vote renders the business judgment rule irrebuttable.

Why Corwin?

Corwin arguably applies a basic principal of stockholder ratification that has long existed under the common law. The Delaware Supreme Court’s decision in Corwin, however, may have also been influenced by other factors. First, it may have been another way for the judiciary to reduce abusive stockholder litigation, which had proliferated over the past decade. Widespread M&A litigation imposes costs on M&A parties, stockholders, and the courts. For that reason, Delaware courts have recently taken steps to discourage meritless claims. Corwin will make it difficult for plaintiffs to pursue post-closing claims (including those that would have nuisance value) because defendants will frequently be able to dismiss the complaint at the pleading stage based on the stockholder vote.

Second, the Delaware Supreme Court may have sought to encourage companies to provide even greater transparency through their disclosures to stockholders when seeking their approval. In addition to federal securities law requirements imposed on public companies, Delaware law requires disclosure of all material facts when stockholders are requested to vote on a merger. Corwin provides a strong incentive for companies to ensure full disclosure.

Third, the Delaware Supreme Court may have been responding to the reality of share ownership in modern society. Today, nearly all US public companies are held by sophisticated institutional investors capable of evaluating complex transactions that affect the value of their investments. The need for judicial review today is less compelling than it was, say, 30 years ago, when companies were held by large numbers of retail stockholders. As the Delaware Supreme Court explained in Corwin:

When the real parties in interest—the disinterested equity owners—can easily protect themselves at the ballot box by simply voting no, the utility of a litigation-intrusive standard of review promises more costs to stockholders in the form of litigation rents and inhibitions on risk-taking than it promises in terms of benefits to them. The reason for that is tied to the core rationale of the business judgment rule, which is that judges are poorly positioned to evaluate the wisdom of business decisions and there is little utility to having them second-guess the determination of impartial decision-makers with more information (in the case of directors) or an actual economic stake in the outcome (in the case of informed, disinterested stockholders).

In other words, institutional shareholders have both the ability and incentive to evaluate merger proposals.

The Corwin Effect in 2016 and Heading Into 2017

Several decisions in 2016 and early 2017 have applied and interpreted Corwin, leading to the following key points:

Corwin appears to be a powerful basis for obtaining dismissal of breach of fiduciary duty claims at the motion to dismiss stage.

In May 2016, the Delaware Supreme Court reiterated the principles underlying Corwin in Singh v. Attenborough. There, the Supreme Court said that the lower court should not have considered post-closing whether the stockholder-plaintiffs had stated a claim for breach of the duty of care because conducting such an inquiry “after an informed, uncoerced vote of the disinterested stockholders would give no standard-of-review-shifting effect to the vote.” It continued that “[w]hen the business judgment rule standard of review is invoked because of a vote, dismissal is typically the result.”

Illustrating the powerful effects of stockholder approval, Vice Chancellor Slights in OM Group dismissed a claim despite acknowledging that the “[c]omplaint sets forth a disquieting narrative” concerning the company’s sale process. He reasoned that “[b]efore the Court launches into its Revlon analysis… it must first account for the fact that another ‘qualified decision maker,’ the disinterested OM stockholders, overwhelmingly approved the transaction.” Finding that the company had disclosed all material facts concerning the transaction, he granted the defendants’ motion to dismiss.

Corwin should also be considered in conjunction with the Delaware Supreme Court’s 2014 decision in Cornerstone. There, the Supreme Court held that directors can seek dismissal even in an entire fairness case unless the plaintiff sufficiently alleges that those directors engaged in non-exculpated conduct (i.e., disloyal conduct or bad faith). In practical terms, Cornerstone generally allows an outside, independent director to be dismissed from litigation challenging an interested transaction unless the plaintiff alleges a breach of the duty of loyalty against that director individually. As described below, the Corwin doctrine seemingly goes further by providing that if there is an informed stockholder vote, then directors who are interested or lack independence can obtain dismissal without having to defend the fairness of the transaction.

The business judgment rule appears to be irrebuttable following a fully informed and uncoerced stockholder vote.

In the immediate wake of Corwin, it was not clear whether plaintiffs would still have the ability to rebut the business judgment rule by pleading facts sufficient to support a breach of fiduciary duty claim. At least four post-Corwin decisions, however, have indicated that the business judgment rule is irrebuttable. In addition, Volcano was affirmed by the Delaware Supreme Court. The oral argument suggested that at least some of the justices do not embrace the term “irrebuttable” even though stockholder approval cuts off claims other than for waste.

Waste claims have little “real-world relevance.”

Once the business judgment rule applies under Corwin, plaintiffs are relegated to claiming waste. In Singh, the Delaware Supreme Court made clear that plaintiffs will rarely be able to state a waste claim. It explained that following a fully informed stockholder vote, “dismissal is typically the result…. because the vestigial waste exception has long had little real-world relevance, because it has been understood that stockholders would be unlikely to approve a transaction that is wasteful.”

Vice Chancellor Montgomery-Reeves made a similar observation in Volcano: because “the test for waste is whether any person of ordinary sound business judgment could view the transaction as fair,” it is “logically difficult to conceptualize how a plaintiff” could succeed after a majority of disinterested stockholders approved the transaction.

Corwin can insulate directors even if they are not independent.

The lower court in Corwin stated that “even if the plaintiffs had pled facts from which it was reasonably inferable that a majority of … directors were not independent, the business judgment standard of review still would apply to the merger because it was approved by a majority of the shares held by disinterested shareholders … in a vote that was fully informed.” The Supreme Court, however, did not explicitly address this issue because it assumed the transaction was not subject to entire fairness. This raised a question because a transaction approved by a majority of interested directors (i.e., directors with a material conflict of interest in the transaction) would typically be subject to entire fairness review.

The issue was subsequently addressed by Vice Chancellor Slights in Larkin v. Shah, who asked “what did Corwin mean by ‘a transaction not subject to the entire fairness standard’”? He concluded that Corwin applies even if a majority of the directors were not independent. He reasoned that the only exception to Corwin is when the transaction involves a controlling stockholder that has a conflict of interest, such as in a freeze-out merger. Thus, it appears that the irrebuttable business judgment rule applies to an interested director transaction, assuming the directors’ conflicts of interest were adequately disclosed.

Corwin applies to two-step transactions and single-step mergers.

Many acquisitions are structured as a tender offer followed by a back-end merger. Although Corwin involved a single-step merger, several Court of Chancery decisions have logically extended Corwin to two-step transactions where a majority of the stockholders tender their shares in the first-step tender offer. Volcano was affirmed on appeal.

Corwin can cut off aiding and abetting claims.

Another key issue is whether, if the directors are protected by an irrebuttable business judgment rule, a plaintiff can still pursue aiding and abetting claims against third parties, such as financial advisors. Although the Court of Chancery has not engaged in an in- depth analysis of this issue, several decisions have dismissed aiding and abetting claims following a conclusion that, under Corwin, the plaintiffs failed to state a predicate breach of fiduciary duty claim against the directors.

To avoid Corwin, plaintiffs must adequately plead a viable disclosure claim, but then the defendants have the burden to show the vote was fully informed.

In Solera, Chancellor Bouchard held that the defendants had the burden of proof to show a vote was fully informed when they raised a stockholder ratification defense. He continued, however, that the plaintiffs have the initial burden of stating a disclosure claim. “It makes little sense,” he explained, “that defendants must bear this pleading burden [without plaintiffs’ initially stating a claim] for it would create an unworkable standard, putting a litigant in the proverbially impossible position of proving a negative.”

What the Future Holds

A Potent Tool for Defendants

As noted above, Corwin will likely result in outright dismissal of most stockholder litigation challenging transactions that have been approved by stockholders. Thus, Corwin will reduce the costs of post-closing litigation and will likely result in a decrease in the overall frequency with which stockholders pursue post-closing claims.

Will Corwin Contribute to More Appraisal Petitions?

As it becomes harder to pursue fiduciary duty claims, more stockholders may exercise appraisal rights in mergers. This would be an unwelcome development since appraisal rights create uncertainty for buyers by giving stockholders the potential to seek payment in excess of the merger price. In addition, many appraisal petitions have nuisance value that incentivizes companies to settle to avoid the legal expenses associated with litigating the fair value of the target company stock, notwithstanding the minimum share requirements discussed below. The dynamics of appraisal proceedings, however, are quite different from fiduciary duty actions. Appraisal trials can be very fact-intensive and involve a quintessential “battle of the experts” given the focus on valuation. In addition, many plaintiffs who might typically pursue fiduciary duty actions may not satisfy the ownership requirements for seeking appraisal. Specifically, recent amendments to the Delaware appraisal statutes impose a de minimis requirement that shares valued at $1,000,000 or constituting 1% of the target company’s outstanding shares must demand appraisal in order for an appraisal action to proceed from a long-form or medium-form merger of a publicly traded target corporation. The recent rise of appraisal actions over the past two years may continue, but whether Corwin and its progeny will contribute to more appraisal actions remains to be seen.

Cause for Alarm?

Some observers may become concerned that the post-Corwin regime is too lax and that it is an over-correction to the problems stemming from widespread M&A litigation. For example, Corwin, Trulia, and other recent decisions might be criticized for making it too difficult to pursue viable fiduciary duty claims, and thus removing (i) an important check on director behavior and (ii) the likelihood of judicial oversight. In addition, some might accuse these rulings of eliminating an incentive for directors (or taking away advisors’ leverage in counseling directors) to “do the right thing” if directors know that lawsuits either are unlikely or will be quickly dismissed after closing. These concerns, however, are based on highly negative views of human nature. They are also inconsistent with the business judgment rule, which presumes that directors have discharged their duties.

Another concern is that Corwin insulates bad faith conduct as long as it is fully disclosed to stockholders. Theoretically, stockholders might accept a transaction that offered them a premium rather than vote down the transaction and continuing with the corporation’s standalone plan, even if directors or officers had acted in bad faith. To take an extreme hypothetical, what if directors disclosed that they illegally bribed a government official or embezzled money in connection with a merger? This issue has not been squarely addressed. Corwin’s progeny has dealt with breaches of the duty of loyalty in the context of a director’s interest or independence, but not bad faith. While interesting, this issue should not be alarming. Delaware courts have generally excelled at ferreting out serious misconduct. If there are specific and credible allegations that directors intentionally harmed a corporation, a Delaware judge is likely to allow the case to proceed beyond a motion to dismiss. Moreover, it seems unrealistic to think that bad faith conduct would ever be disclosed at the level that would be required by Delaware courts to insulate it. Nevertheless, assuming that bad faith conduct was fully disclosed and the transaction was still approved, it remains to be seen whether the directors still could obtain dismissal.

Future Battlegrounds

Corwin will shift the focus of practitioners and litigators to the adequacy of disclosure. Plaintiffs may also have an incentive to challenge transactions pre-closing because they benefit from a lower pleading standard (“colorability”) to seek discovery—although their ability to settle those claims in exchange for supplemental disclosures has become more difficult after Trulia. Alternatively, would-be plaintiffs may try to inspect corporate books and records in order to prepare a disclosure claim. It is still unclear how Delaware will deal with disclosure claims that are pursued post-closing, particularly when a plaintiff did not possess information pre-closing that would have suggested a disclosure violation.

Another relatively untested area is whether a plaintiff could escape Corwin by alleging that the stockholder vote was “coerced.” Under the enhanced scrutiny standard, a transaction falls short if it was coercive, preclusive, or fell outside the range of reasonableness. The coercion issue examines whether “the defendants have taken actions that operate inequitably to induce [stockholders] to tender [or vote] their shares for reasons unrelated to the economic merits of the offer.” Stockholder plaintiffs historically argued that termination fees (and particularly naked no-vote fees) were so large as to coerce the stockholder vote, but these claims got little traction. Coercion also can arise in controlling stockholder transactions, if the controller makes explicit or implicit threats about what would happen if the minority stockholders do not approve a transaction. In Larkan, Vice Chancellor Slights indicated that board-level conflicts are unlikely to result in actionable coercion that would undermine a stockholder vote. More recently, Vice Chancellor Slights asked for supplemental briefing on this issue. Because coercion offers a way to call into question the effectiveness of a stockholder vote, and because the consequences of stockholder approval are so significant, we should see more efforts by plaintiffs’ lawyers to argue that particular transaction structures are coercive.

The Final Word Resides Within the Delaware Supreme Court

The Delaware Supreme Court issued Corwin and Singh, but those rulings did not reach many of the issues discussed above. The Delaware Supreme Court will likely weigh in on more issues flowing from Corwin in the near future.

The complete publication, including footnotes, is available here.

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