The Diminishing Availability of Post-Closing Damages in Non-Controller M&A Transactions

Philip Richter is a partner and Co-Head of the Mergers & Acquisitions Practice and Warren S. de Wied is partner and member of the Mergers & Acquisitions Practice at Fried, Frank, Harris, Shriver & Jacobson LLP. This post is based on a Fried Frank publication by Mr. Richter, Mr. de Wied, Scott B. LuftglassAbigail Pickering Bomba, Philip Richter, Robert C. Schwenkel, and Gail Weinstein. This post is part of the Delaware law series; links to other posts in the series are available here.

Both Miami v. Comstock (Aug. 24, 2016) and Larkin v. Shah (Aug. 25, 2016) reflect the evolution of recent Delaware jurisprudence toward affording significantly greater deference to directors’ and stockholders’ decisions in non-controller transactions. In both cases, the Delaware Court of Chancery dismissed the plaintiffs’ post-closing actions for damages that were based on claims of breaches of fiduciary duties by the target board in connection with a public company merger. The court found, in each case, that the stockholder vote approving the merger was fully informed; found that the transaction did not involve a controller; applying the Delaware Supreme Court’s seminal 2015 Corwin decision, evaluated the claims under the business judgment rule standard of review; and dismissed the claims at the early pleading stage of litigation.

Key Points

Ongoing increased deference to boards and stockholders. The decisions underscore:

  • The increased prevalence of the Delaware courts’ deferring to the decisions of independent and disinterested target company boards, and of disinterested, non-coerced, and fully informed stockholders, to approve M&A transactions;
  • In our view, in the courts’ fact-specific inquiries, a trend toward imposing a higher bar than in the past for plaintiffs to establish that a board was not independent and disinterested or that stockholders were not fully informed; and
  • The potency of Corwin in non-controller situations, with the court, in both of these cases, having applied business judgment review on the basis that the stockholders were fully informed and had approved the challenged transaction.

Comstock: application of business judgment rule despite factual context. In Comstock, the court applied the business judgment rule (following stockholder approval of the transaction) even in the context of serious, non-conclusory allegations challenging the sale process and the proxy disclosures. It remains to be seen, however, to what extent the court’s result is instructive for future situations. Importantly, Comstock’s unusual procedural situation—involving the Delaware Supreme Court’s reversal of a pre-closing injunction that had been issued by the Court of Chancery and that had required the target board to conduct a 30-day go-shop solicitation to seek and consider potentially superior proposals—led the court, in this post-closing action, to consider the post-signing sale process (and the disclosures relating to it) as irrelevant to the stockholders’ decision to approve the transaction.

Larkin: business judgment rule will apply even to duty of loyalty claims. In an important clarification of the applicability of Corwin, the court stated in Larkin that claims of breaches of a board’s fiduciary duties of loyalty (based on alleged conflicts of interest, gross negligence, or bad faith by directors) will be subject to the deferential business judgment rule in post-closing actions challenging non-controller transactions that have been approved by stockholders (so long as the stockholders were fully informed).

Discussion

Continued increased deference to boards and stockholders; decline in M&A litigation. We note that the evolution of the substantive law toward increased deference to boards and stockholders in M&A matters—combined with the Delaware courts’ rejection (under the Court of Chancery’s seminal January 2016 Trulia decision) of previously typical pre-closing disclosure-only settlements—has resulted in a significant decline in M&A-related litigation. Cornerstone Research has reported that, in the first half of 2016, 64% of announced M&A transactions (valued over $100 million) were challenged in litigation, down from over 90% in each year from 2010 through 2014. Further, litigation is more frequently being brought outside Delaware, in jurisdictions viewed as potentially more plaintiff-friendly—with 26% of M&A lawsuits having been brought in Delaware over the most recent nine months, down from over 60% in prior periods.

Comstock: Application of business judgment rule notwithstanding serious allegations, including the following:

  • Conflicted CEO ran the solicitation process, with little board involvement: The plaintiffs alleged that the CEO-Chairman-director-10% stockholder of the target company (who was the lead negotiator of and favored the deal that had been enjoined, and who had threatened not to support the deal unless his terms for employment with the post-merger company were agreed to) ran the sale process while providing little information to, “going behind the back” of, and getting almost no direction or oversight from the special committee;
  • No confidential information was provided to the financial advisor or potential bidders: The CEO instructed the financial advisor that neither the financial advisor to the special committee nor potential bidders would receive target company confidential information (including forecasts); and
  • Financial advisor allegedly made errors and omissions that devalued the alternative bid received: The plaintiffs alleged that the special committee’s financial advisor (i) when reviewing the alternative bid received during the solicitation process, made errors in its analysis of the existing bid, which overvalued it as compared to the alternative bid; (ii) advised the board that the alternative bid was 12% above the target’s then stock price and should be at least 30% above to constitute a “superior proposal” (although the injunction did not define what a superior proposal would be and, under the merger agreement, the determination was to be made based on the good faith judgment of the board); and (iii) did not directly compare the two bids.

The court gave little credence to these allegations, stating that certain claims were simply restatements of previously made substantive arguments, disguised as disclosure claims; that others were mere “quibbles with [the] financial advisor’s work”; and that Delaware law does not require disclosure constituting “a play-by-play of negotiations.” Importantly, however, the court noted the “unique posture of this case”—with the reversal of the preliminary injunction having reinstated the no-shop provision in the parties’ merger agreement, so that “the board was prevented from pursuing the [alternative bid] in any case.” As a result, the court wrote, questions concerning the integrity of the solicitation process—including details of the alternative bid, the bankers’ and board’s analysis of that bid, and alleged conflicts of interest relating to the bid—“logically would have ceased to be meaningful to stockholders.” It is an open question whether the same claims would have been dismissed if made in the context of a more typical procedural setting where the sale process had not been rendered (as this process was characterized by the court) “a nullity.”

Larkin: Important clarification that business judgment rule will apply even to duty of loyalty claims. In Corwin, the Court of Chancery stated that the shift of the standard of review to the business judgment rule in post-closing actions relating to stockholder-approved transactions would not occur if the pre-closing standard of review had been entire fairness (the most stringent standard of review). It was clear that the shift to business judgment review would be barred if, as was the case in Corwin, entire fairness applied due to a conflicted controller being involved—that is, a controller stood on both sides of, or received a unique benefit from, the transaction. (The only exception would be if all of the MFW prerequisites to business judgment review of a controller transaction—one of which is the fully informed, non-coerced approval of the transaction by the disinterested stockholders—were satisfied.) However, it was not clear whether the shift to business judgment review also would be barred if entire fairness applied due to the transaction having been approved by a conflicted board—that is, a board that was not independent, was motivated by personal rather than corporate interests, or that acted with gross negligence or in bad faith.

In dicta in Corwin, Chancellor Bouchard had suggested that the shift would occur even in the case of a conflicted board. The issue was not addressed by the Delaware Supreme Court in its (September 2015) affirmance of Corwin or in its later (May 2016) Singh v. Attenborough (“Zale III”) decision. In Chelsea Therapeutics (May 2016), Vice Chancellor Glasscock commented that a shift in the context of a conflicted board remained an open issue. In Volcano (June 2016), Vice Chancellor Montgomery-Reeves suggested that there would be a shift (stating that, under Corwin, shareholder approval renders the business judgment rule “irrebuttable”). In Larkin, Vice Chancellor Slights stated that there would be a shift in the case of a conflicted board. While the weight of authority appears to favor a view that the standard does shift in the context of a conflicted board, we note that the Delaware Supreme Court has not yet specifically addressed the issue.

Court indicates disclosure claims made for the first time in a post-closing action will not necessarily be barred. The disclosure claims at issue in Comstock were raised by the plaintiff for the first time after the challenged transaction had closed. The court stated that there was “persuasive force” to the target company’s argument that the doctrine of laches should bar disclosure claims that are made for the first time in a post-closing action for damages. The court commented that the plaintiff had disregarded the “preference under Delaware law for disclosure claims to be litigated before a stockholder vote so that if a disclosure violation exists, it can be remedied by curing the informational deficiencies, thus providing stockholders with the opportunity to make a fully informed decision,” and that there “appear[ed] to have been a calculated delay [by the plaintiff] in asserting [the disclosure claims].” However, the court nonetheless decided the disclosure claims on the merits, citing the relevance of the disclosure claims to the determination whether the stockholder approval had been fully informed and, thus, whether, under Corwin, the business judgment rule would be the applicable standard of review for the plaintiff’s fiduciary duty claims relating to the sale process.

Heightened practical importance of disclosure; open issues as to the content of disclosure and the burden of proof. As business judgment review applies under Corwin only if the stockholder vote was fully informed, adequate disclosure is a predicate for a shift, post-closing, to business judgment review. We note that a shift in the context of a conflicted board would be possible under Corwin only if the board conflict was adequately disclosed to stockholders before the vote on the transaction. Thus, for example, stockholder approval would not “cleanse” a transaction as to which the board was conflicted unless the conflict had been adequately disclosed prior to the stockholder vote. We note that it remains to be seen what would constitute adequate disclosure, in a Corwin setting, of a director’s or banker’s conflict—or, indeed, of grossly negligent or bad faith conduct by either. We note, also, that, in the Court of Chancery’s 2016 Volcano decision, the court stated that, although a plaintiff generally bears the burden of proving a material deficiency when asserting a duty of disclosure claim, in the Corwin context, the burden of proof would be on the defendant to demonstrate that the stockholders were fully informed. In Larkin, however, without addressing the issue, the court appeared to impose the burden of proof on the plaintiffs.

Plaintiffs’ exposure for reimbursement of target company expenses in complying with an injunction that is later overturned. In Comstock, the court stated that (i) there is an implicit presumption (albeit rebuttable) in favor of awarding damages for a wrongful injunction and (ii) the reversal of an injunction on appeal, standing alone, is sufficient to establish it as having been “wrongful” (even if there was no abuse of discretion in the injunction having been granted). The court permitted the target company to recover, from the $650,000 bond that the plaintiff had posted, the $542,000 of damages the target sought for the fees and costs associated with the solicitation process that had been ordered by the court as part of the injunction. The court rejected the plaintiff’s argument that the damages claim should be denied because the target failed to mitigate its damages when it chose to lift the stay of the injunction and to conduct the court-ordered solicitation process during the appeal rather than choosing to await the outcome of the appeal before beginning the solicitation process. The court noted that such a delay would not only have postponed a $3 billion transaction by a month, but also would have put the target at risk of losing the transaction it had agreed (given the merger agreement’s drop dead date and related provisions, including a condition that there not be a preliminary injunction outstanding against the transaction as of a specified date).

Practice Points

Continued importance of best practices. Although companies can be even more confident than in the past that, if stockholders have approved a transaction, the board’s decisions are likely to be subject to deferential judicial review and to pass muster in post-closing actions, it is still the case that the overall factual context of a case can be determinative of the judicial outcome. Boards should be mindful that (i) the premise of the court’s general deference to stockholder-approved transactions is full disclosure to stockholders; (ii) even when business judgment review may apply post-closing, a board will have to plan and manage the sale process to pass muster pre-closing under the standard of review that will apply at that stage; and (iii) a board will be advantaged—from a business reputation standpoint in addition to the impact on potential legal liability—if it adheres to best practices, including a majority of directors being independent and disinterested; when appropriate, retaining independent legal and financial advisors; obtaining relevant information and materials; and being diligently involved in the process.

Although M&A litigation has declined, federal cases have increased and cases that are brought are pursued aggressively. As more companies adopt Delaware-only forum selection bylaws (which cover only state claims) and more jurisdictions adopt the Trulia approach (as the Seventh Circuit did in its August 2016 Walgreens decision), plaintiffs have been increasingly turning to making federal claims to challenge M&A transactions. According to Cornerstone Research, in the first half of 2016, there was a 167% increase in the filing of federal M&A lawsuits as compared to the prior six months. We note also that, while M&A litigation overall has decreased, in our experience, those cases that are brought have been pursued aggressively by plaintiffs’ counsel.

Reminder of the validity of post-signing passive market checks in Revlon situations. We note that the Delaware Supreme Court’s unanimous 2014 decision in the earlier stage of the litigation involving the Comstock situation (C&J Energy v. Miami) indicated a shift from past precedent that had emphasized the limited circumstances under which passive shopping alone would be deemed by the courts to be sufficient in the context of a Revlon transaction. Past precedent had established a burden for utilizing a passive shopping-only approach that was based on the judgment of the directors as informed by the particular circumstances (including, for example, the likelihood of competing bids, the benefits and risks of the single bidder strategy, and the nature of the deal protection devices). By contrast, the Supreme Court emphasized in C&J Energy that the stockholders themselves could decide (through their vote on the transaction) whether a passive shopping approach had been value-maximizing. The acceptance of a post-signing passive shopping approach was confirmed by the Delaware Supreme Court in Zale III.

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