Delaware Supreme Court Orders Entire Fairness Review

This post comes to us from Robert S. Reder, Alan J. Stone, Peter Heller and Dean Sattler of Milbank, Tweed, Hadley & McCloy LLP. This post is part of the Delaware law series, which is cosponsored by the Forum and Corporation Service Company; links to other posts in the series are available here.


In a previous Client Alert, [1] we discussed a decision of the Delaware Court of Chancery dismissing a stockholder suit that alleged breach of fiduciary duty by directors who initiated, but later abandoned, a sale process that had generated three attractive offers. In Gantler v. Stephens [2], the Court of Chancery applied the business judgment rule to the board’s conduct, rather than the Unocal [3] standard of enhanced review, because the directors’ actions were not “defensive” in nature. In affording the directors the benefit of the business judgment presumption, the Court of Chancery found that the directors breached neither their duty of loyalty nor their duty of care, and therefore declined to undertake an “entire fairness” review of the board’s conduct.

On January 27, 2009, the Delaware Supreme Court reversed the Court of Chancery’s decision. In the Supreme Court’s view, the complaint pled “sufficient facts to overcome the business judgment presumption,” thereby requiring an examination of plaintiffs’ allegations under the entire fairness standard of review.[4] The Supreme Court’s analysis provides helpful insight into the nature of the pleading required to overcome the presumption of the business judgment rule in the M&A context. The Gantler decision also clarifies the nature of the fiduciary duties owed by corporate officers to a Delaware corporation, as well as the scope and application of the shareholder ratification doctrine under Delaware law.

Background

In August 2004, the board of directors of First Niles Financial, Inc. authorized a process to sell the company, and retained financial and legal advisors to assist. At the next board meeting, with the sale process underway, management advocated abandoning the process in favor of a so-called “going private” transaction. The board did not act on management’s proposal, but instead allowed the sale process to continue.

Eventually, the board received indications of interest from three bidders, two of whom stated that they would terminate the incumbent directors upon consummation of the merger. The board decided to pursue two of these bids, including one which did not take a position regarding retention of the directors. These two bids offered premiums from 3.4% to 6.8% over the then-current First Niles share price, figures that the board’s financial advisor opined were within an acceptable range.

The board authorized management to permit these two bidders to conduct due diligence. One of the bidders withdrew its offer when management failed to comply with its due diligence requests. Management also initially failed to provide the other bidder with requested due diligence materials, but relented after this bidder also threatened to withdraw. Apparently satisfied with the results of its due diligence investigation, the remaining bidder raised its offer twice and, again, the board’s financial advisor opined that the revised offers were within an acceptable range. Nevertheless, without discussing the revised offers, the board rejected the bid at a special meeting and abandoned the sale process.

Several weeks later, the board returned to discussing management’s plan to take First Niles private through a reclassification of the shares of holders of 300 or fewer shares of common stock into a new series of non-voting preferred stock. After an oral presentation on the contemplated privatization by outside counsel during which no written materials were furnished, the board determined, presumably without the benefit of advice from a financial advisor, that the reclassification plan was fair to all shareholders. The board then mailed a proxy statement describing the reclassification to First Niles shareholders, who voted to approve the plan.

Plaintiff shareholders sued, alleging that, among other things, the directors and officers of First Niles had breached their fiduciary duties to First Niles shareholders by rejecting the merger offer and abandoning the sale process.[5] In determining the applicable standard of review, the Court of Chancery held that Unocal did not apply because the complaint did not allege any “defensive” action by the board. In addition, the Court of Chancery found that an entire fairness review was inappropriate because, among other reasons, an “entire fairness review would be inconsistent with the broad power allocated to directors.” Accordingly, the Court of Chancery applied the business judgment rule and, on that basis, determined that the facts alleged did not rebut the presumption that the directors had exercised adequate business judgment in abandoning the sale process. Plaintiffs appealed this decision to the Delaware Supreme Court.

Directors’ Fiduciary Duty Claims

Supreme Court’s Analysis

First, the Supreme Court agreed with the Court of Chancery’s determination that enhanced scrutiny under Unocal was not applicable to the board’s decision to abandon the sale process. Plaintiffs’ claim, according to the Supreme Court, “sounds in disloyalty, not improper defensive conduct … [and] does not allege any hostile takeover attempt or similar threatened external action from which it could reasonably be inferred that the defendants acted ‘defensively’.”

On the other hand, the Supreme Court strongly disagreed with the Court of Chancery’s failure to apply an entire fairness review to the directors’ conduct. In this regard, the Supreme Court noted that although “[a] board’s decision not to pursue a merger opportunity is normally reviewed within the traditional business judgment framework,” the facts alleged were sufficient to overcome this presumption and require a full judicial review of whether the directors had satisfied their duty of loyalty.

In reaching this decision, the Supreme Court noted that a board’s motivation to retain corporate control in the face of a bidder’s statement that incumbent directors would not be retained will not, alone, support a finding that the directors acted disloyally. Rather, “the plaintiffs must plead, in addition to a motive to retain corporate control, other facts sufficient to state a cognizable claim that the Director Defendants acted disloyally.”

In the Supreme Court’s view, the plaintiffs met this burden by pleading facts “sufficient to establish disloyalty of at least three (i.e., a majority) of the remaining directors, which suffices to rebut the business judgment presumption.” The Supreme Court highlighted several factors important to its analysis, including that the reclassification proxy statement itself admitted that the directors had a conflict of interest because the directors were in a position to structure the reclassification to benefit their interests “differently from the interest of the unaffiliated stockholders.” The Court also conducted a director-specific analysis, finding that a majority of the members of the board were conflicted for one reason or another. The disqualifying conflicts identified by the Court included that (i) one bidder withdrew its offer when the Chairman and CEO never responded to its due diligence request, which the Court deemed sufficient to demonstrate that the Chairman acted in his own “personal financial interest, as opposed to the interests of the shareholders,” and (ii) two of the other directors owned businesses that provided services to First Niles which would be in jeopardy if a takeover was completed.

Accordingly, the Supreme Court reversed the Court of Chancery’s decision and remanded the case for an entire fairness review of the board’s conduct.

Conclusion

The primary, and unsurprising, message of Gantler is that in making a decision not to pursue a potential change of control transaction, a board of directors must undertake the same careful and deliberative process it would apply in determining to pursue such a transaction. Step one of such a process would be an open discussion among the directors as to any interests that any of them might have with respect to a decision not to pursue a transaction. A board should also retain and heed the advice of expert financial and legal advisors, carefully document its proceedings, manage its conflicts and focus on the role that truly independent directors play in the decision-making process. If, as in Gantler, board members are perceived to have personal interests that could influence their decisions, or if the board does not carry out its decision-making process in a manner appropriate for the relative importance or complexity of the matter at hand, then a court may very well determine that the business judgment presumption has been rebutted and, as a result, the actions of the directors will be analyzed under the much more exacting and intrusive entire fairness standard of review.

It is also important to note that the Supreme Court’s decision to subject the First Niles board’s conduct to an entire fairness review – instead of affording the directors the protection of the business judgment rule – does not alter the ability of a board to “just say no” to a takeover proposal (even one generated by a sale process initiated by a board) if the board determines that acceptance of the offer would not be in the best interest of the company. This is implicit in the Supreme Court’s decision not to subject the First Niles board’s actions to an enhanced level of scrutiny under Unocal. Of course, the result will be different when a board adopts defensive measures in the face of a hostile bid.

Nor does Gantler indicate that boards have less protection when making a business judgment relating to a potential change in control transaction as compared to other circumstances. In fact, the Supreme Court specifically stated that normally a “board’s decision not to pursue a merger opportunity is … reviewed within the traditional business judgment framework. In that context the board is entitled to a strong presumption in its favor because implicit in the board’s statutory authority to propose a merger, is also the power to decline to do so.” Unfortunately for the First Niles directors, the facts pled, in the Supreme Court’s view, rebutted that presumption.

Other Notable Holdings of the Court

The Gantler decision also provides clarification of two previously unclear aspects of Delaware corporation law.

Fiduciary Duties of Officers

In Gantler, the Delaware Supreme Court, for the first time, explicitly ruled that officers of Delaware corporations owe the same fiduciary duties of care and loyalty to their corporations as those owed by directors of Delaware corporations.[6] Applying the same standards of loyalty and care to First Niles’ officers as it did to its directors, the Court found that two of First Niles’ officers breached their fiduciary duty of loyalty by, among other things, failing to respond adequately to the bidders’ due diligence requests.

In light of this ruling, it is appropriate, to the extent that they have not done so already, for Delaware corporations to be sure that their officers receive the same education with respect to their duties of loyalty and care under Delaware law as it has become customary for their directors to receive.

Shareholder Ratification Doctrine

The Delaware Supreme Court also took the opportunity in Gantler to clarify, and in fact narrow, the doctrine of shareholder ratification of director conduct “[to] restore coherence and clarity to this area of our law.” First, the Court limited this doctrine to its “classic” form, under which a “fully informed shareholder vote” can only ratify “director action that does not legally require shareholder approval in order to become legally effective.” Moreover, the Court declared that a ratification vote is only effective to “subject the challenge to director action to business judgment review, as opposed to ‘extinguishing’ the claim all together … [by] obviating all judicial review of the challenged action … ”

Applying this standard to the facts presented in Gantler, the Court ruled that the ratification doctrine did not apply to the First Niles shareholder vote on the reclassification plan because that plan, insofar as it involved an amendment to the company’s Certificate of Incorporation, was required by statute to be approved by shareholders. In addition, the Court noted that, even if ratification was available, plaintiffs’ “complaint states a cognizable claim that the Reclassification Proxy was materially misleading,” thereby eliminating “an essential predicate for applying the doctrine, namely, that the shareholder vote was fully informed”, and therefore effective to ratify the conflict at issue.

Footnotes:

[1] See our previous Client Alert entitled “Delaware Chancery Court Allows Board to ‘Just Say No’ to a Takeover Proposal“, dated March 14, 2008.
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[2] Gantler v. Stephens, No. 2392-VCP, slip op. at 20-21 (Del. Ch. Feb. 14, 2008).
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[3] Unocal Corp. v. Mesa Petroleum Co., 493 A.2d 946 (Del. 1995).
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[4] Gantler v. Stephens, No. 132, 2008 (Del. Jan. 27, 2009).
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[5] Plaintiffs also attacked the disclosures contained in the proxy statement describing the reclassification plan, as well as the board’s decision to move ahead with the reclassification plan.
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[6] In In re Walt Disney Co., Deriv. Litig., 2004 WL 2050138, Chancellor Chandler noted that “To date, the fiduciary duties of officers have been assumed to be identical to those of directors.” Of course, corporate officers, unlike corporate directors, do not benefit section 102(b)(7) of the Delaware General Corporation Law, which allows corporations to include a provision in their Certificates of Incorporation exculpating their directors from personal liability for breach of their duty of care.
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