Second Corwin Denial Due to Restatement Process

Meredith E. KotlerRoger A. Cooper, and Mark E. McDonald are partners at Cleary Gottlieb Steen & Hamilton LLP. This post is based on a Cleary memorandum by Ms. Kotler, Mr. Cooper, Mr. McDonald, and Kal Blassberger, and is part of the Delaware law series; links to other posts in the series are available here.

The Delaware Court of Chancery recently denied Corwin cleansing [1] in a case involving the sale of a public company while it was engaged in a restatement of its prior audited financial statements. See In re Tangoe, Inc. S’holders Litig., C.A. No. 2017-0650-JRS (Del. Ch. Nov. 20, 2018). If this sounds familiar, that is because it is the second time in two years that the Court of Chancery has denied a motion to dismiss shareholder litigation on Corwin grounds where the target was in the middle of a restatement process. [2] Together, these decisions suggest that if a board decides to sell the company while under a cloud of an ongoing restatement process, it would need to satisfy a heightened level of scrutiny of its disclosures in order to obtain the benefit of Corwin. The court in Tangoe, however, sought to reassure practitioners that it is not impossible to satisfy Corwin in a case involving an ongoing restatement by the target, and provided a checklist of the kinds of facts that, if disclosed, would result in pleading stage dismissal of a shareholder lawsuit in such a case.

The target in this case was in the midst of what the court called a “regulatory storm.” It had announced that it would need to restate its audited financial results for 2013, 2014 and the first three quarters of 2015. A year later, after continuous failures to timely file quarterly and annual reports (without a public explanation for the delay), NASDAQ delisted the company’s stock. At the same time, the SEC was also threatening to deregister the company given its failure to comply with its reporting requirements. Finally, during this time, a hedge fund had acquired a 10% stake and was threatening to oust the board in a proxy contest.

In the midst of this storm, the board approved a transaction to sell the company for $6.50 per share (which represented a significant negative premium to the company’s value before the restatement was announced). In the meantime, while this transaction was being negotiated, the company’s board, barred by SEC rules from issuing new equity compensation while the restatement was pending, approved a new incentive plan under which directors would receive shares that would fully vest upon a change in control. A majority of the target’s shares tendered into the transaction, which was then completed by a short-form merger.

Vice Chancellor Slights focused on two specific omissions in the target’s Schedule 14D-9. First, although neither Schedule 14D-9 nor Delaware law requires that shareholders who are being asked to tender into a transaction be provided with audited financial statements in all cases, he found that in this case the “information vacuum” caused by the “sporadic and heavily qualified” nature of the financial information provided to stockholders by the board, compounded by the company’s failure to file 2016 quarterly and annual reports and hold annual stockholder meetings for the previous three years, “supports a reasonable inference that stockholder approval of the Transaction was not fully informed” in the absence of audited financial statements. Although this holding could be read to suggest that the absence of audited financial statements would be a material omission in all restatement-pending cases, that would appear to be inconsistent with the court’s insistence that it is possible for a board that decides to sell the company during a restatement process to satisfy Corwin. The court’s analysis more likely turned on its perception that the board itself was responsible for this omission, having “diverted focus and resources from the Restatement process and fixed its sights on Board compensation and a quick deal with any of the financial sponsors who were willing to look past the Restatement delays.”

Second, the court held that in light of the company’s delisting from NASDAQ and threats of deregistration from the SEC, it was particularly important for the board to explain to stockholders what was happening with the restatement. For example, the court noted that the board’s decision not to share with stockholders that the forensic accounting of the company’s financial statements was nearly complete “deprived them of the opportunity to consider whether to stay the course and allow the Restatement to proceed or whether to sell as the consequences of the unfinished Restatement were still unfolding.” [3]

Having found that the transaction did not satisfy Corwin, the court then turned to whether the complaint should be dismissed under Cornerstone [4] for failing to allege a non-exculpated breach of the directors’ fiduciary duty of loyalty. Here, too, the court found that plaintiffs had pled sufficient facts to support a rational inference that the board had “acted out of material self-interest that diverged from the interests of the shareholders.” Most significantly, the court credited plaintiffs’ allegation that the directors’ approval of a new incentive plan followed closely by a sale of the company in the midst of the restatement process were motivated by the directors’ desire to enrich themselves at the expense of the shareholders. The court also noted that the threat of a proxy contest further suggested that the board might have been acting to extricate themselves from a difficult situation and not to further the best interests of the shareholders.

Key Takeaways

Although this is now the second time that the Court of Chancery has denied a Corwin-based motion to dismiss in a case involving a target that was engaged in a restatement, Vice Chancellor Slights insisted that these decisions should not be read to mean “that directors simply cannot achieve business judgment rule deference when they make difficult decisions amid a ‘regulatory storm.’” He cautioned, however, that “[e]xtraordinary transactions proposed to stockholders in the midst of extraordinary times be explained with commensurate care.” In particular, boards should carefully and thoroughly explain “[1] how the company sailed into the storm, [2] how the company has been affected by the storm, [3] what alternative courses the company can take to sail out of the storm, and [4] the bases for the board’s recommendation that a sale of the company is the best course.”

Endnotes

1See Corwin v. KKR Fin. Hldgs. LLC, 125 A.3d 304 (Del. 2015) (holding that business judgment protection applies to mergers that are not subject to entire fairness review and are approved by a fully informed and uncoerced vote of a majority of disinterested shareholders).(go back)

2The first was In re Saba Software, Inc. S’holder Litig., 2017 WL 1201108 (Del. Ch. Mar. 31, 2017), holding that information relating to the status of a stalled effort to complete a restatement of financials was material to stockholders’ determination of whether to approve a proposed sale of the company and that calling a vote on the sale of a company in the midst of an unresolved restatement that had not been adequately explained to stockholders was “situationally coercive.”(go back)

3Although the court resolved the Corwin-cleansing issue on the basis that the stockholders were not fully informed when they approved the transaction, Vice Chancellor Slights also suggested (without deciding) that he would find the shareholder vote was the “product of coercion” for the same reasons as in Saba.(go back)

4In re Cornerstone Therapeutics Inc. S’holder Litig., 115 A.3d 1173 (Del. 2015) (holding that complaint must allege facts showing an unexculpated breach of fiduciary duty as to each director defendant).(go back)

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