Defenses Available to Directors and Financial Advisors

Ethan A. Klingsberg and Meredith E. Kotler are partners in the New York office of Cleary Gottlieb Steen & Hamilton LLP. This post is based on a Cleary Gottlieb publication by Mr. Klingsberg, Ms. Kotler, and Darryl G. Stein. This post is part of the Delaware law series; links to other posts in the series are available here.

On May 6, the Delaware Supreme Court issued an Order that sets forth concisely the contours of the defendant-favorable standards for determining liability of directors and their advisors following the closing of sales of control of companies. These standards are available, however, only following an uncoerced and informed approval of the sale by the target stockholders, including a majority of the disinterested holders. Thus, while the Order clarifies a roadmap (set forth recently in Corwin v. KKR and discussed here) for obtaining easy dismissal of post-merger damages claims against directors and advisors, the need for directors and their advisors to avoid, or at least ferret out and disclose, any deficiencies in sales processes remains as strong as ever. Only if these deficiencies are avoided or uncovered and disclosed in advance of the shareholder approval will the lower courts be able to rely on these defendant-favorable standards to dismiss claims.

The Supreme Court issued this Order upon reviewing the Chancery Court’s dismissal of post-closing damages claims against the board of Zale and its financial advisor. As discussed previously here, the claims by the shareholder plaintiff were based on the alleged failure of the Zale board to make sufficient advance inquiries into, and the alleged delay by the board’s financial advisor to notify the Zale board of, the financial advisor’s conflicts. The lower court found that the shareholders, including a majority of the disinterested holders, approved the sale of Zale after the disclosure in the proxy statement of these alleged shortcomings and therefore concluded that this fully informed shareholder approval required the court to find that no breach of duty occurred unless a director’s conduct failed to satisfy the gross negligence standard (i.e., a “wide disparity” between the process used and the process that “would have been rational”). The Supreme Court agreed with this reasoning, including the decision of the Chancery Court to dismiss the claims, except the Court clarified that the gross negligence standard is not defendant-favorable enough after there has been an informed shareholder approval. The proper standard following informed shareholder approval is whether there has been “waste,” which occurs only if “no person of ordinary or sound business judgment” could have found the transaction to be fair. The Supreme Court noted strongly that there is “little real-world relevance” to “the vestigial waste exception” when there has been an informed shareholder approval, since informed shareholders cannot be presumed to be irrational, and therefore dismissal on the pleadings is appropriate in these instances where the only issue is whether waste occurred.

This Order in the Zale case is good news for target boards that either have well-run sale processes or, if their process had any deficiencies, have adequately disclosed these deficiencies in advance of obtaining shareholder approval of the transaction. But where does this leave target boards’ financial advisors, which, as occurred in the Zale suit, are named from time to time as co-defendants alongside the target directors? Does dismissal of the claims against the directors similarly merit dismissal of the post-closing damages claims against their advisors for aiding and abetting breaches of duty by the directors?

Per the Supreme Court Order in Zale, the answer is yes, with one exception. The exception arises only in a scenario that turned out not to be determinative in the Zale case: Where the court dismisses the claims against the directors not under the rule of Corwin, which provides for the applicability of the director-friendly “waste” standard following informed shareholder approval, but under the rule of In re Cornerstone (discussed here), which confirms that exculpatory provisions in charters mandate dismissal of damages claims against directors who acted in good faith no matter what the context, even those contexts involving conflicts where heightened “entire fairness” review applies. If the dismissal of the claims against the directors is the result of the directors’ having relied in good faith on their advisors, who were in turn “intentionally dup[ing]” or perpetrating a “fraud on the board,” then the dismissal of the claims against the directors does not merit dismissal of the claims against the advisors for aiding and abetting. But even in these instances, the Supreme Court stresses, if the advisors acted without scienter—i.e., without knowledge—then the claims for aiding and abetting must be dismissed. Moreover the Supreme Court highlights its “skeptic[ism] that the supposed instance of knowing wrongdoing—the late disclosure of a business pitch that was then considered by the board, determined to be immaterial, and fully disclosed in the proxy—produced a rational basis to infer scienter.” Still, determinations of whether or not scienter existed are fact-specific and the easier path to dismissal of aiding and abetting claims is the path used in the Zale case: dismissal of the claims against the financial advisors, together with the claims against the director defendants, as a result of the informed shareholder approval.

To sum up:

1. After an uncoerced, informed shareholder approval that includes a majority of the disinterested holders, lower courts should dismiss on the pleadings all post-closing damages claims against directors for breaches of duty and against advisors for aiding and abetting. The only claims that theoretically survive this shareholder approval are those for “waste,” which are typically not tenable following an informed shareholder approval.

2. In the absence of such a shareholder approval:

  • Post-closing damages claims against directors for breach of duty should be evaluated under the gross negligence standard (i.e., a “wide disparity” between the process used and the process that “would have been rational”) in addition to being subject to the exculpatory provisions of charters that mandate dismissal of damages claims where the directors acted in good faith.
  • Post-closing damages claims against advisors for aiding and abetting must establish both scienter (i.e., knowledge) and a predicate breach by the directors. Even though breach of duty of care claims against directors acting in good faith will be dismissed if the charter has an exculpatory provision, that breach can still be the basis of an aiding and abetting claim where the advisor knowingly provided “misleading or incomplete advice tainted by the advisor’s own knowing disloyalty.”

3. As a practical matter, the path to dismissal described in item 1 is much more efficient. Thus, well-run board processes, including advance inquiries into and consideration of advisor conflicts, and adequate disclosure of any flaws in these processes is now of more value than ever to directors and their advisors.

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