2014 Delaware Decisions and What They Mean For 2015

Delaware has long been known as the corporate capital of the world, and it is now the state of incorporation for 66 percent of the Fortune 500 and more than half of all companies whose securities trade on the NYSE, Nasdaq and other exchanges. Each year, the Delaware courts issue a number of significant opinions demonstrating that the Delaware courts are neither stockholder nor management biased. Many of those recent and important cases are discussed in this post, which is intended to provide sufficient detail so as to be helpful to in-house counsel, but is also written in a way so that the often-long and complex Delaware decisions can be easily understood by directors and other fiduciaries. Takeaway observations are also provided.

Delaware’s preeminence in business law starts with its corporate code (the Delaware General Corporation Law) and alternative entity statutes, which are continuously reviewed and enhanced with innovations designed to meet the expanding needs of Corporate and Financial America.

The Delaware Court of Chancery and the Delaware Supreme Court have helped the state maintain its preeminence by striking a balance in the application of these laws between entrepreneurship by management and the rights of investors. Jurisdiction over a company and its management can be obtained based on the state of incorporation, and Delaware’s courts are not just popular venues for resolving business disputes but are now the preeminent courts in the United States for resolving challenges to actions by boards of directors, such as breach of fiduciary duty claims, merger and acquisition litigation and virtually any issue implicating corporate governance and compliance with Delaware’s business laws. In fact, for more than ten years, an annual assessment conducted by the United States Chamber of Commerce has ranked Delaware first among the court systems in all 50 states, noting the Delaware courts’ fairness and reasonableness, competence, impartiality and timeliness in resolving disputes.

Delaware’s guiding principles remain: strict adherence to fiduciary duties; prompt enforcement of articles of incorporation, bylaws and merger agreements; and the maximization of stockholder value. The business judgment rule remains alive and well in Delaware for directors who reasonably inform themselves of important information before making decisions, who are free of economic or other disabling conflicts of interest, and whose only agenda is that of advancing the best interests of the corporation. While the facts and legal analyses confronting directors are usually complex, the cases often boil down to the smell test. So long as independent directors can articulate why, in their best judgment, they acted as they did and why they believed those actions were in the best interests of the corporation, the Delaware courts will respect their decisions.

Curbing Stockholder Litigation: Exclusive Forum and Fee-Shifting Provisions

In an effort to control the phenomena of multi-forum litigation, in which plaintiffs bring the same suit in multiple jurisdictions simultaneously, corporations have been adopting, either by charter amendment or bylaw approval, exclusive forum and/or fee-shifting provisions. Exclusive forum provisions require that lawsuits over the internal affairs of a Delaware corporation be brought in Delaware. Fee-shifting provisions, which are currently clouded in controversy, are essentially one-sided “loser pays” provisions.

The significance of this problem becomes shockingly clear when one considers the statistics on M&A litigation. While the 2014 information is still being compiled, a study prepared by Matthew D. Cain (University of Notre Dame, Department of Finance) and Steve M. Davidoff (Ohio State University, Michael E. Moritz College of Law) on M&A deals in 2013 showed:

• 97.5 percent of all transactions resulted in litigation
• Each transaction resulted in an average of 7 lawsuits (an all time high)
• 41.6 percent of all transactions experienced multi-jurisdictional litigation (down from 51.8 percent in 2012)
• Median attorneys’ fee awards per settlement were US$485,000

Exclusive Forum Provisions

As reported in last year’s Update, the Court of Chancery, in Boilermakers Local 154 Retirement Fund v. Chevron Corp., 73 A.3d 934 (Del. Ch. 2013), held that boards of directors of Delaware corporations may adopt exclusive forum bylaws that are binding on stockholders. The court addressed the validity of the bylaws under the DGCL as well as the question of whether bylaws enacted by a board of directors without stockholder involvement can be enforced, as a contractual matter, against stockholder plaintiffs.

The court made two primary holdings. First, the court found that Section 109(b) of the DGCL permits an exclusive forum selection bylaw because it allows a corporation’s bylaws to “contain any provision, not inconsistent with law or with the certificate of incorporation, relating to the business of the corporation, the conduct of its affairs, and its rights or powers or the rights or powers of its stockholders, directors, officers, or employees.” The court held that forum selection bylaws “easily meet these requirements.” Second, the court held that forum selection provisions are enforceable against stockholder plaintiffs, even though the bylaws were board-enacted, because bylaws are part of a flexible contractual relationship between stockholders and a corporation. Based on the certificate of incorporation, stockholders understand whether a particular board of directors has the power to enact bylaws. If the certificate of incorporation grants a board the power to unilaterally amend the corporation’s bylaws, as permitted by Section 109(a), then the board may enact bylaws and thereby unilaterally alter the flexible contract.

The Chevron case provided for exclusive jurisdiction in Delaware, but in a 2014 case involving a Delaware corporation—City of Providence v. First Citizens Bancshares, Inc., et al., 2014 WL 4409816 (Del. Ch. Sept. 8, 2014)—the company’s bylaw provided for exclusive jurisdiction in the United States District Court for the Eastern District of North Carolina, or, if that court lacks jurisdiction, any North Carolina state court with jurisdiction. Delaware’s new Chancellor, Andre C. Bouchard, upheld the bylaw based on the same rationale in Chevron and dismissed the case.

Takeaways

• 1. The Delaware case law is important, but it is when the company and management are facing lawsuits in other states that they really need the exclusive forum provisions to be enforced—and that requires non-Delaware courts to accept their validity and enforce them. To enhance enforcement, such provisions should be adopted by charter amendment (if possible) rather than by management-approved bylaw. For example, in Roberts v. TriQuint Semiconductor, 2014 WL 4147465 (Cir. Ct. Or. Aug. 14, 2014), an Oregon court refused to enforce a forum selection bylaw adopted at the same time as the merger agreement being challenged by stockholders because of “the closeness of the timing of the bylaw amendment to the board’s alleged wrongdoing, coupled with the fact that the board enacted the bylaw in anticipation of this exact lawsuit.”
• 2. Mandatory arbitration for corporate governance disputes will be the next challenge. One could argue that certain actions expressly permitted by the DGCL should be excluded—e.g., 211, 220, 225 and 262 actions—because the DGCL authorizes them without condition, but the ationale for exempting even these actions from a validly adopted charter or bylaw provision is not clear (other than a court making a public policy judgment call).

Fee-Shifting Provisions

In ATP Tour, Inc. et al. v. Deutscher Tennis Bund et al., — A.3d —, 2014 WL 1847446 (Del. May 8, 2014), the Delaware Supreme Court, sitting en banc, held that a Delaware corporate bylaw that requires a losing claimant to pay the legal fees and expenses of the defendants is not invalid per se, and if otherwise enforceable can be enforced against losing claimants whether or not they were already stockholders when the relevant bylaw provision was adopted. The court’s ruling was in response to four certified questions from the United States District Court in Delaware.

In 2006, the board of directors of ATP Tour, Inc. a Delaware non-stock (also known as a membership) corporation that organized tennis tournaments adopted a bylaw providing that if any member or members brought or supported a claim against the corporation or any other member, the claimant would then be obligated (and if more than one claimant, jointly and severally obligated) to pay the legal fees and expenses of those against whom the claim was brought if the claimant “does not obtain a judgment on the merits that substantially achieves, in substance and amount, the full remedy sought…” Members of ATP Tour, Inc. filed claims against the corporation and the board. The district court, having found for the defendants on all counts, certified the question of the fee-shifting provision to the Delaware Supreme Court.

Citing Section 109(b) of the DGCL for the baseline rule that the bylaws may contain any provision not inconsistent with law or the corporation’s certificate of incorporation, the court noted that bylaws are presumptively valid and that a bylaw that “allocated risk among parties in intra-corporate litigation would appear to satisfy the DGCL’s requirement that bylaws ‘must relat[e] to the business of the corporation, the conduct of its affairs, and its rights and powers or the rights and powers of its stockholders, directors, officers or employees.’” Although the corporation in this case was a non-stock corporation, the analysis is applicable to stock corporations and non-stock corporations alike, with the members of non-stock corporations being analogous to stockholders.

The court held that no principle of common law prohibits directors from enacting fee-shifting bylaws and that because contracting parties may modify the “American Rule” under which litigants pay their owns costs to provide that “loser pays,” a fee-shifting bylaw (bylaws being “contracts among a corporation’s shareholders”) would be a permissible contractual exception to the American Rule. The court noted further that an intent to deter litigation, as a fee-shifting provision inherently does, was not invariably an improper purpose.

The court did note, however, that the enforceability of such a bylaw provision would depend on the manner in which it was adopted and the circumstances under which it was envoked, and that “[b]ylaws that may otherwise be facially valid will not be enforced if adopted or used for an inequitable purpose.”

Takeaways

• 1. Because this is the first case touching on this issue, the reaction of ISS, proxy advisory firms and others to the extension of the ATP rationale to general corporations is yet to be fully known. The court was careful to point out that such a bylaw may be facially valid but could be rendered unenforceable if used for an inequitable purpose.
• 2. If ATP could be extended to general corporations, the logistics are easy. If a company has an exclusive forum provision, it could make the fee-shifting provision apply to any and all claims covered by the exclusive forum provision, which would cover class actions, derivative claims and claims involving the internal affairs doctrine. Also, the adoption of a fee-shifting bylaw well before the possibility of any litigation would improve its chances of enforcement.
• 3. It is notable that despite the court’s analysis of the fee-shifting mechanics in light of the “American Rule” versus “loser pays,” the bylaw provision in question only shifted the expense to a losing claimant, and is arguably asymmetric in its effect. However, for class actions and derivative actions, a court has to approve of any fee to plaintiff’s counsel, so a provision that says corporate-loser pays plaintiff-winner may not be enforceable.

Legislation

All of the above considerations may become irrelevant. After wrangling behind closed doors, on May 29, 2014, the Corporation Law Section of the Delaware State Bar Association voted to recommend to the Delaware Legislature a statutory amendment that would quash the adoption of ATP-type bylaw provisions for general corporations—essentially making a legislative end-run around the Supreme Court’s decision. Proposed changes to the DGCL are often given great deference: the Delaware State Bar Association recommends a change and the Delaware Legislature gives great weight to the advice of Delaware legal experts, which has worked quite well and has created the most widely-respected corporate legal framework in the world. Statutory changes generally occur on an annual cycle where new changes take effect on August 1. However, in an unusual turn of events, the proposed legislation was opposed by several corporations and has now been tabled for later discussion in 2015. In the interim, rather than rushing to have their boards adopt fee-shifting bylaws provisions, corporations will do well to step back and coolly observe the Delaware process at work. That said, some corporations have adopted fee-shifting bylaws and the issue is surely going to be well-litigated in the near future.

Two-Tiered Poison Pill Targeted at Hedge Fund Activists Survives Challenge

In Third Point LLC v. Ruprechet, 2014 WL 1922029 (Del. Ch. May 2, 2014), the Court of Chancery found that a two-tiered poison pill adopted by Sotheby’s, which limited activist investors to 10 percent stakes but permitted passive investors to acquire up to 20 percent, was a reasonable and therefore legally permissible response to rapid acquisitions of its stock by activist hedge funds.

Third Point and several other hedge funds filed Schedule 13Ds with the SEC disclosing the amount of their holdings and their intent to effectuate corporate change at Sotheby’s. In response, Sotheby’s board adopted a poison pill with a two-tiered structure: Schedule 13G filers (those without any intent to influence the company) were permitted to acquire up to a 20 percent stake in Sotheby’s, but Schedule 13D filers (those with an intent to effectuate change at the company) were limited to a 10 percent stake. Third Point alleged that Sotheby’s board breached its fiduciary duties by adopting the pill in the first instance and by later rejecting Third Point’s request for a waiver.

The court reviewed the board’s action under the Unocal standard—derived from the Delaware Supreme court’s seminal decision in Unocal v. Mesa Petroleum Co., 493 A.2d 946 (Del. 1985) – which requires a court to scrutinize defensive measures to determine whether a board had reasonable grounds for perceiving a threat to the company and whether its response to that threat was “reasonable” in relation to the type of threat perceived. The court found that there was a sufficient factual basis in the record for Sotheby’s board to reasonably perceive a threat to the company. The company was facing the possibility of “creeping control” by several hedge funds which were acquiring its stock simultaneously and the court accepted the contention that it was not uncommon for hedge funds to form a “wolfpack” and coordinate their acquisition of stock or takeover efforts.

The court also found that the pill’s two-tiered structure fell within the range of reasonableness. The court acknowledged that the two-tiered structure was “discriminatory,” but went on to observe that “it also arguably is a ‘closer fit’ to addressing the Company’s needs to prevent an activist or activists from gaining control than a ‘garden variety’ [single-tier] rights plan,” which has broad application.

Takeaway

The Third Point decision reaffirms the Delaware court’s recognition of the board’s dominant role in protecting the short-and long-term corporate strategy and its broad authority when responding to perceived “threats” to the corporation, including the ability to implement a carefully-crafted pill to deal with threats from activist investors.

Controlling-Stockholder Transactions: Evolving Standards of Review

Delaware’s treatment of controlling-stockholder transactions is in the midst of an important evolutionary stage. One aspect involves required protective measures and the other involves application of the same standard to both negotiated mergers and tender offers.

Why the Standard Of Review is So Important

The standard of review applicable to a transaction has enormous implications for any litigation—which inevitably follows from the announcement of a large public-company deal. Regardless of the merits of such suits, the standard of review affects the timing within which unmeritorious actions can be dismissed, and this affects litigation costs, people costs due to time devoted to discovery, etc., and it creates business uncertainty as well as uncertainty about personal liability for the directors involved.

In carrying out the business of the corporation, management is protected by the Business Judgment Rule, which is the standard by which courts review most, but not all, board decisions. The Business Judgment Rule reflects the legal premise that decisions made by directors who are fully informed and free from conflicts of interest should not, and will not, be second-guessed by a court, even if the business decision under review turns out to have been “poor.” To receive a favorable presumption of the Business Judgment Rule, a director must be disinterested and independent (i.e., satisfy the fiduciary duty of loyalty), review and consider all pertinent information reasonably available (i.e., satisfy the fiduciary duty of care), and not act in a manner or with a motive prohibited by statute or otherwise improper, and at all times act in good faith when discharging his or her fiduciary duties. This is a process inquiry. If the directors are not conflicted and are fully informed, the action will be dismissed and the substance of the transaction will not be reviewed.

If the Business Judgment Rule cannot be asserted, the transaction is not void but voidable; however, the heightened “entire fairness” standard will be applied and, under such circumstances, the burden is on the directors to prove that the decision or transaction at issue is “entirely fair” to both the company and its stockholders. Even if the transaction is approved by an independent special committee or a vote of a majority of the minority stockholders, such procedural safeguards only shift the burden back to a stockholder-plaintiff to prove that the transaction was unfair, which means the substance of the transaction will be evaluated by a court. This is very different from transactions that are eligible for Business Judgment Rule protection where the court merely evaluates whether a board was fully informed (duty of care) and whether a majority of the board was disinterested and independent (duty of loyalty). Satisfying the entire fairness standard is extremely difficult because the board must demonstrate both fair process and fair price. Failure to establish the entire fairness of the decision or transaction can render it void and lead to personal liability for directors. Endeavoring to satisfy the entire fairness standard means extensive discovery, a trial on the merits, a time-table that can now be more than a year instead of a few months, and a legal budget in the millions of dollars instead of a few hundred thousand.

Negotiated Mergers

On March 14, 2014, the Delaware Supreme Court issued an en banc opinion in Kahn v. M&F Worldwide Corp., 88 A.3d 635 (Del. 2014), affirming then-Chancellor (now Chief Justice) Leo E. Strine, Jr.’s ruling in In re MFW S’holders Litig., 67 A.3d 496 (Del. Ch. 2013) that a controlling stockholder may secure business judgment review of its purchase of the corporation through a going private merger by conditioning consummation ab initio upon the approval of (i) a special committee of independent directors and (ii) a majority of the minority stockholders.

Nearly two decades ago, in Kahn v. Lynch Commc’n Sys., 638 A.2d 1110 (Del. 1994), the Delaware Supreme Court held that entire fairness review applies to controlling-stockholder transactions, and that approval by a special committee or a majority of the minority stockholders would mean that the plaintiff, not the defendant, would bear the burden of persuasion on entire fairness at trial. Until the MFW opinion, no case presented the opportunity for the Delaware Supreme Court to rule on the effect of using both procedural protections together. MacAndrews & Forbes owned 43 percent of M&F Worldwide (MFW). MacAndrews & Forbes announced its interest in buying the rest of MFW’s equity in a going private merger at US$24 per share. MacAndrews & Forbes simultaneously announced it would not proceed with the merger absent the approval of a special committee of independent directors and the approval of a majority of the minority stockholders. MFW’s board of directors established a Special Committee to consider the proposed transaction, which met eight times over three months, negotiated a US$1 increase in merger consideration, and approved the deal. A substantial majority of MFW’s minority stockholders (65 percent) voted in favor of the merger. Plaintiff stockholders commenced an action in the Court of Chancery, first seeking injunctive relief based on alleged disclosure issues, but they later abandoned those claims in favor of a post-closing damages action alleging the board of directors breached its fiduciary duties. The defendant directors moved for summary judgment on the breach of fiduciary duty claim, which the Court of Chancery granted. The plaintiffs appealed.

In its opinion, the Delaware Supreme Court summarized the new standard applicable to buyouts by controlling stockholders as follows:

The business judgment standard of review will be applied if and only if: (i) the controller conditions the procession of the transaction on the approval of both a Special Committee and a majority of the minority stockholders; (ii) the Special Committee is independent; (iii) the Special Committee is empowered to freely select its own advisors and to say no definitively; (iv) the Special Committee meets its duty of care in negotiating a fair price; (v) the vote of the minority is informed; and (vi) there is no coercion of the minority.

The Supreme Court reasoned that this new standard is appropriate because: (i) the undermining influence of a controlling stockholder does not exist in every controlled merger setting; (ii) the “dual procedural protection merger structure optimally protects the minority stockholders in controlling buyouts,” (iii) it is consistent with the central purpose of Delaware law to defer decisions to independent, fully-informed directors; and (iv) the dual protection merger structures ensures a fair price. While the Court of Chancery’s opinion suggested a new standard could lead to dismissal of complaints at the pleading stage, the Delaware Supreme Court indicated that obtaining early dismissal could be much more difficult. In footnote 14 of its opinion, the court explained that the plaintiff’s complaint would have likely survived a motion to dismiss under this new framework, reasoning that plaintiff’s “allegations about the sufficiency of the price call into question the adequacy of the Special Committee’s negotiations, thereby necessitating discovery on all of the new prerequisites to the application of the business judgment rule.” As nearly all plaintiffs’ lawsuits involving similar transactions challenge the adequacy of the price, it appears that early dismissal will be extremely difficult until greater clarity on this area of the law is developed.

The Supreme Court emphasized that defendants must establish that the challenged transaction qualifies for business judgment protection prior to trial in order to avoid entire fairness review: “If, after discovery, triable issues of fact remain about whether either or both of the dual procedural protections were established, or if established were effective, the case will proceed to a trial in which the court will conduct an entire fairness review.” The court did note, however, that “[b]are allegations that directors are friendly with, travel in the same social circles as, or have past business relationships with the proponent of a transaction or the person they are investigating are not enough to rebut the presumption of independence.”

Takeaway

The level or standard of review applied to special committees will impact the future of MFW. Nothing in the MFW opinion alters what the Delaware Supreme Court held in Americas Mining Corp. v. Theriault, 51 A.3d 1213 (Del. 2012), when it affirmed the Court of Chancery’s 105-page post-trial opinion in In re Southern Peru Copper Corporation Shareholder Derivative Litigation, 52 A.3d 761 (Del. Ch. 2011). There, the Court of Chancery concluded that there is “no way” to determine whether a special committee is “well-functioning” without “taking into consideration the substantive decisions of the special committee, a fact intensive exercise that overlaps with the examination of fairness itself.” A 1997 Delaware Supreme Court case, Kahn v. Tremont Corp., 694 A.2d 422 (Del. 1997), required the Chancellor to determine whether the committee was well-functioning by, as he put it, taking “a look back at the substance, and efficacy, of the special committee’s negotiations, rather than just a look at the composition and mandate of the special committee.” The court acknowledged that there are “several problems with this approach,” the most obvious being that it reduces the incentive to use a special committee if all of its decisions can be second-guessed and weakens its utility as a “reliable pre-trial guide to the burden of persuasion.” On appeal, the Delaware Supreme Court, although given the opportunity to hold otherwise, reaffirmed the status of the law on review of special committee decisions. In fact, it quoted the Tremont passage with approval in its affirmance.

Tender Offers

Several years ago, in In re CNX Gas Corporation Shareholders Litigation, 4 A.2d 397 (Del. Ch. 2010), the Court of Chancery developed a “unified standard” for reviewing controlling stockholder going-private transactions. The unified standard provides business judgment rule review, but only if the transaction is: (1) negotiated and recommended by a special committee; and (2) approved by a majority of the minority stockholders. Historically, Delaware courts have applied different standards of review for negotiated mergers and transactions accomplished via a unilateral tender offer. Negotiated mergers have been reviewed under the “entire fairness” doctrine and unilateral tender offers (assuming no disclosure issues) have left the cashed-out stockholders with appraisal rights and no fiduciary review. If the Delaware Supreme Court were to affirm the unified standard enunciated in CNX, it would eliminate the dichotomy between controlling-stockholder tender offers and negotiated cashout deals.

The CNX case arose from the acquisition of CNX Gas Corporation (CNX) by CONSOL Energy, Inc. (CONSOL). Prior to the acquisition, CONSOL owned 83.5 percent of CNX’s common stock and its representatives controlled the CNX board. CONSOL commenced a tender offer for all publicly held shares of CNX. The tender offer was subject to a non-waivable condition that a majority of CNX’s outstanding minority shares be tendered, excluding shares owned by the officers and directors of CONSOL or CNX.

The Court of Chancery applied its two-prong unified standard—i.e., negotiation and approval by a special committee and approval by a majority of the minority—and held that neither requirement had been met. Because the special committee created to evaluate the offer did not affirmatively recommend the deal, the court found the first prong of the standard was not met. The court also noted that the special committee was not initially empowered to negotiate with the controlling stockholder and did not have full board authority such as the ability to adopt a poison pill or pursue alternatives. With regard to the second prong, the court found that the majority of the minority condition was ineffective because certain interested shares were counted as part of the minority for purposes of satisfying the condition.

The defendants petitioned the court to certify an interlocutory appeal of its refusal to dismiss the action. The court granted the request and provided additional analysis in its opinion certifying the question for review. See In re CNX Gas Corporation Shareholders Litigation, 2010 WL 2705147 (Del. Ch. July 5, 2010). The Delaware Supreme Court exercised its discretion and, unfortunately, refused to accept the appeal, stating that it would prefer to wait until the factual record is developed. See In re CNX Gas Corporation Shareholders Litigation, 30 A.3d 782 (Del. 2010).

Takeaway

Sophisticated parties understand the standard of review dynamics in structuring transactions involving controlling stockholders. So the question here is: should the dichotomy between controlling-stockholder tender offers and negotiated cashout deals be eliminated? There are strong views on both sides.

Those that oppose unification emphasize that for negotiated mergers, the DGCL requires a board to first approve a merger agreement and adopt a resolution recommending its advisability to the stockholders. The stockholders cannot unilaterally propose and vote on a merger because the board, by express statutory mandate, is a gatekeeper. There is no such requirement for tender offers. “Entire fairness” applies to negotiated controlling-stockholder transactions because the controlling stockholder has the ability to exercise control over some or all of the directors and therefore dictate the terms, often to the detriment of the minority who can be cashed out against their will due to the voting power of the controlling stockholder. However, if the controlling stockholder is merely going to the market with a tender offer, the minority gets to decide whether or not to tender—if the price is right they will and vice versa. Requiring a controlling stockholder to have the company appoint a special committee to play a role can cause delay, cause litigation over the makeup of the committee, etc., and it defeats the right to go directly to the stockholders and bypass the board altogether.

The argument for unification is grounded on the basis for imposing entire fairness review to controlling-stockholder transactions in the first place. Whether a transaction is friendly or hostile, Delaware has always recognized that the board has a role and can do many things to protect the interests of the company and its stockholders (from a mere recommendation to not tender to the adoption of a pill). A controlling stockholder has the ability to exploit information and relationships, and exert influence over what a board does or does not do, to the detriment of the minority. Imposition of a unified standard would eliminate any doubt about the fairness of the process and price, and would therefore promote the maximization of stockholder value. Without it, the same rationale for differential treatment of tender offers could be used to extend business judgment protection to deals conditioned only on a vote of a majority of the minority—and that is clearly not Delaware law.

The complete publication is available here.