The Delaware Courts’ Increasingly Laissez Faire Approach To Directorial Oversight

Miles D. Schreiner is an attorney at Monteverde & Associates PC. This post is largely based on a recent memo by Mr. Schreiner. This post is part of the Delaware law series; links to other posts in the series are available here.

In a wave of recent cases, judges in Delaware, the state that has pioneered the nation’s corporate laws but holds less than one-third of one percent of the U.S. population, have issued opinions that dramatically curtail the rights of millions of shareholders across the country. For decades, legal scholars have opined that Delaware’s corporate-friendly laws attract droves of corporations with no actual ties to the state to incorporate there, to the detriment of investors. Several recent opinions regarding the effect of so-called shareholder “ratification” further solidify their argument that shareholders’ rights have hit rock-bottom under the stewardship of the Delaware courts, and that the time has come for legislative intervention, including federal regulation of directors’ fiduciary obligations.

Most recently, and perhaps most alarmingly to anyone concerned with shareholders’ rights, the Delaware Court of Chancery, in In re Volcano Corp. Stockholder Litig., No. 10485-VCMR, 2016 Del. Ch. LEXIS 99, at *27-*28 (Del. Ch. June 30, 2016), held that “the approval of a merger by a majority of a corporation’s outstanding shares pursuant to a statutorily required vote of the corporation’s fully informed, uncoerced, disinterested stockholders renders the business judgment rule irrebuttable.” The court in Volcano went on to find that “if the business judgment rule is ‘irrebuttable,’ then a plaintiff only can challenge a transaction on the basis of waste—i.e., that it cannot be attributed to any rational business purpose.” Such a standard is virtually insurmountable; as the Delaware Supreme Court recently stated in Singh v. Attenborough, No. 645, 2016 Del. LEXIS 276, at *2 (Del. May 6, 2016): “When the business judgment rule standard of review is invoked because of a vote, dismissal is typically the result. That is 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.”

Under the standard articulated in Volcano, Singh, and Corwin v. KKR Fin. Holdings LLC, 125 A.3d 304, 309 (Del. 2015), the key inquiry in shareholder litigation challenging corporate transactions submitted to a shareholder vote is whether shareholders were “fully informed” when voting. Such a significant factual inquiry at the motion to dismiss stage presents a significant problem for shareholders—how do they know if they are “fully informed” about key details, including the negotiations surrounding the transaction, director’s and management’s personal interests in the transaction, and the financial advisor’s valuation analyses and interests, when all of the relevant information sits exclusively in the possession of the likely defendants? The answer is, they don’t. Indeed, shareholders can only know as much about the transaction as their potential adversaries choose to disclose to them in the necessary Securities and Exchange Commission filings. [1] This is particularly true in light of a string of Delaware Court of Chancery rulings that have significantly raised the standard for obtaining expedited discovery, and denied expedition without even considering the materiality of disclosure issues because of the largely illusory availability of post-close damages for disclosure claims. Not surprisingly, in a world where “[c]onflicts between the board and financial experts who issue fairness opinions have become the norm instead of the exception,” juicy pieces of material information often emerge if and only when plaintiffs are able to obtain discovery—a task that was not always so difficult under what is commonly referred to as Delaware’s “plaintiff-friendly” motion to dismiss standard and the previously low-threshold for obtaining expedited discovery. Those “plaintiff-friendly” days appear to be long gone.

The inequity created by making the determinative issue on a motion to dismiss whether shareholders were “fully informed” is exemplified by the litigation surrounding Occam Networks, Inc. 2010 merger with Calix Inc., a case that recently settled for $35 million. In Chen v. Howard-Anderson, C.A. No. 5878-VCL (Del. Ch. 2010) (“Occam”), the court denied the defendants’ motion to dismiss claims that Occam’s directors breached their fiduciary duties by selling Occam too cheaply in a roughly $200 million merger with Calix, finding that the transaction was subject to the heightened “enhanced scrutiny” standard, and that based on the allegations in the complaint and the record developed during expedited discovery, plaintiffs had adequately stated a claim. Notably, plaintiffs were actually able to conduct expedited discovery, and in January 2011 the Court issued a preliminary injunction blocking the parties from proceeding with the shareholder vote on the merger until corrective disclosures were made. Significantly, on February 7, 2011, Occam made the required disclosures, and on February 22, 2011, a majority of Occam’s shareholders voted to approve the merger. With plaintiff’s initial disclosure claims remedied as a result of the injunction, and with a majority of the company’s shareholders having voted to approve the merger after the corrective disclosures were issued, defendants today would have undoubtedly immediately sought to dispose of the case on the basis that the business judgment rule irrebutably applied and rendered plaintiff’s remaining claims unviable. And, based upon recent holdings from cases like Singh and Corwin, they likely would have succeeded. But the defendants in Occam did not do so, and the court therefore held that enhanced scrutiny applied at the motion to dismiss and summary judgment stages and did not reach “the potential effect of a fully informed, non-coerced stockholder vote on the standard of review.”

The facts that emerged after the shareholder vote in Occam illustrate why the “irrebuttable business judgment rule” standard is inherently unjust and threatens to shield troubling acts of corporate malfeasance. During fact discovery in the Occam case, plaintiffs learned that their initial disclosure claims and preliminary “expedited discovery” investigation only scratched the surface of defendants’ misconduct. Specifically, during more robust fact discovery, plaintiffs amassed extensive evidence indicating that the background section of the proxy “more closely resembled a sales document than a fair and balanced factual description of the events leading up to the Merger Agreement.” The Court noted that “the evidence suggesting a slanted and misleading approach to the background section [was] particularly troubling because the defendants [had] asked the court to take judicial notice of the contents of the Proxy Statement and rely on its factual accuracy both for purposes of a motion to dismiss and in connection with the preliminary injunction hearing.” In other words, had the Occam court held earlier in the litigation that the business judgment rule irrebutably applied because the corrective disclosures rendered shareholders “fully informed”, shareholders likely would never have known that the corrective disclosures and limited information garnered during expedited discovery actually only addressed a few of several serious disclosure violations. Indeed, in addition to the misleading disclosures about the sale process, plaintiffs also unearthed disclosure issues concerning the reliability of the company’s projections and the description of the information that the company’s financial advisor relied upon for its fairness opinion.

Occam serves as a prime example of why fiduciary duty claims challenging a merger should not be rendered dead on arrival just because shareholders cannot point to glaring disclosure deficiencies at the motion to dismiss stage, particularly if they are denied the opportunity to conduct discovery. Corporate defendants will contend that shareholders should not be allowed to conduct discovery to enable them to first state a cognizable claim. But very few areas of law present an “information asymmetry” problem as significant as it is in shareholder litigation. And no other area of law punishes plaintiffs so harshly for lacking access to information. If recent ratification holdings stand, fiduciaries who control the flow of information get to invoke an irrebutable presumption that, for all intents and purposes, ends litigation before plaintiffs have a fair chance to state their case by telling shareholders and the court “trust us, we disclosed everything you need to know.” Delaware courts’ recent rulings essentially allow a plaintiff’s lack of access to information to be used as both a sword and a shield, and significantly raises the pleading standard. As another legal scholar has argued, “when the applicability of a substantive judicial standard depends on a shareholder decision made on an informed basis, plaintiff shareholders may have to know facts that have not been disclosed to them. Absent a means to find such facts that have not been publicly disclosed, such a substantive judicial standard does not work.” Thus, at the very least, the presumption that the business judgment rule applies upon a purportedly “fully informed” shareholder vote should be rebuttable, which would give shareholders a fighting chance to overcome the significant hurdle created by the rule by pleading sufficient facts that a board violated “either the duty of care or duty of loyalty—even based on facts that were disclosed to stockholders before they approved a transaction…”

In sum, “Delaware, has taken a largely laissez faire attitude to directorial oversight…”, and recent decisions from the state’s courts threaten to further erode shareholders’ already limited rights. As a respected law professor wrote in advocating for the federal regulation of corporate law, “[t]he only way out of this mess is to have corporate law be federal law, and for Congress or the SEC to define the obligations of corporate managers and directors.” Until then, absent a shift in Delaware law, for an overwhelming majority of aggrieved shareholders, the only available recourse will be attempting to (somehow) prevail under the increasingly inequitable laws of an increasingly challenging forum.

Endnotes:

[1] While shareholders could theoretically investigate potential disclosure issues via an appraisal action or a Section 220 books and records action, various issues make such tactics largely impractical. First, because of economic realities, appraisal actions cannot realistically be pursued by small shareholders. Indeed, the Delaware legislature recently passed a bill that will limit appraisal rights to holders of $1 million or more of a company’s stock or 1 percent of the outstanding shares, whichever is less. Steven Davidoff Solomon, Delaware Effort to Protect Shareholders May End Up Hurting Them, N.Y. Times, May 24, 2016, (“[T]he $1 million minimum seemingly unfairly knocks out small shareholders but not professional hedge funds. There should be a remedy for a small shareholder who feels ill-treated.”). With respect to Section 220 actions, shareholders still need to establish a “credible basis to infer wrongdoing through documents, logic, testimony or otherwise,” a burden that may not be met even in circumstances that would appear relatively egregious to the average shareholder. See City of Westland Police & Fire Ret. Sys. v. Axcelis Techs., Inc., 1 A.3d 281, 287 (Del. 2010) (affirming order dismissing § 220 action premised upon board’s action to override shareholder’s decision to withhold voting for certain directors by rejecting directors’ resignations). Thus, shareholders are faced with the same problem – how do they establish a “credible basis to infer wrongdoing” when all of the necessary evidence is in the possession of their potential adversaries? Further, even if a shareholder is successful in bringing a § 220 action, the limited scope of the documents defendants are required to make available prevents shareholders from inspecting “all the documents that he or she believes are relevant or even likely to lead to information relevant to that purpose.” Norfolk County Ret. Sys. v. Jos. A. Bank Clothiers, Inc., No. 3443-VCP, 2009 Del. Ch. LEXIS 20, at *18 (Del. Ch. Feb. 12, 2009). Thus, corporate directors are largely able to limit the scope of information they share with shareholders who pursue § 220 actions, and can refuse to produce documents that call the accuracy of proxy disclosures into question. And finally, it remains unclear “whether a stockholder — who makes an inspection demand but does not file suit until after the corporation loses possession, custody, and control [of the relevant books and records]” which may be the case in a change-of-control merger, “loses standing to later file the action.” Litterst v. Zenph Sound Innovations, Inc., No. 7700-ML, 2013 Del. Ch. LEXIS 251, at *14 (Del. Ch. Sept. 30, 2013).
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