High Bar for Challenge of Business Decisions by an Independent Board

In City of Coral Springs Police Officers’ Pension Plan v. Jack Dorsey, Block, Inc., et al (May 9, 2023), the Delaware Court of Chancery dismissed a lawsuit against the directors of Block, Inc. (a tech company, originally called Square, Inc., led by former Twitter CEO Jack Dorsey) challenging Block’s $237.3 million acquisition in 2021 of an 86.23% stake in TIDAL, a music streaming company 27% owned by Shawn Carter (who is professionally known as Jay-Z). The court dismissed the case after finding that the plaintiffs did not establish that the independent directors of Block acted with bad faith (and that, therefore, the plaintiffs did not establish demand futility).

Key Points

• The decision serves as a reminder of the very high bar for a finding that an independent board acted in bad faith. Even in the context of a decision to approve what was “by all accounts, a terrible deal” following a minimal and flawed process, an independent and disinterested board will not have liability unless it acted in bad faith. This decision indicates that, generally, the court will not find bad faith unless the board essentially did almost nothing to evaluate the transaction before approving it. In this case, where the directors received a presentation about the transaction, had three short meetings, and asked management questions, they had not acted in bad faith, the court found—even though, apparently, the answers to the questions they asked all strongly indicated that the deal should not be done.
• The court continues its trend in recent years of criticizing a flawed process even when reaching a holding for the defendants. This is another case in which, although the court held that the director defendants had no liability, the court’s recitation of the background facts and other commentary made clear the court’s view that Dorsey may have been motivated by his friendship with Carter and that the directors had not done a good job and had made what was obviously a “terrible business decision.”

Background

Before the acquisition of TIDAL, Block was a fintech company that processed mobile payments. It had never been involved in the music streaming business and had not had any plans to do so. Jack Dorsey—Block’s founder, CEO, Chairman, and, at the relevant times, owner of between 48% and 51% of the company’s voting power—developed the idea for the acquisition while he and Carter (who were friends) and their families were spending the summer in the Hamptons. On August 25, 2020, Dorsey proposed the acquisition, via videoconference from the Hamptons into a regular meeting of Block’s board. The board was comprised of 11 members, all of whom—other than, allegedly, Dorsey (based on his friendship with Carter)—were independent and disinterested in the transaction. The board formed a Transaction Committee comprised of four of the independent directors to consider the proposal. Over the following months, the Committee learned that TIDAL’s entry into the music streaming business had been “unsuccessful” and that its signed musicians would have no legal obligation to remain on the platform after a merger. Nonetheless, the Committee approved the transaction. When the transaction was announced, Block’s stock price declined 7%. The acquisition closed in April 2021, at which time Carter joined the board of the combined company.

Following a Section 220 books and records investigation, a Block stockholder brought suit against Dorsey (as a controller) and Block’s directors, claiming they had breached their fiduciary duties in approving the acquisition. The defendants moved to dismiss for failure to establish demand futility—that is, they alleged that the directors faced a substantial likelihood of liability for approving the transaction and therefore could not have impartially responded to a demand to bring the derivative suit. Chancellor Kathaleen St. J. McCormick dismissed the case, finding that the directors did not face a substantial likelihood of liability for approving the transaction and therefore that the plaintiffs did not establish demand futility.

Discussion

Problems facing TIDAL and the transaction. The Transaction Committee learned the following:

• By mid-2020, TIDAL had amassed only 2.1 million paying subscribers (while, for example, Spotify had 138 million, Apple Music had 60 million, and Amazon Music had 55 million); and TIDAL had “logged multimillion-dollar losses for each of the preceding ten quarters,” and had accrued $127 million in liabilities (mostly from unpaid royalties to record labels);
• in 2020, TIDAL had obtained a $50 million loan from Carter personally to help it through its difficulties;
• Between 2015 and 2020, TIDAL had “churned through” five different CEOS;
• TIDAL had only semi-formal contracts with musicians in most cases; was losing the major contracts it had; and had suffered a public falling-out with Kanye West (an initial TIDAL stockholder, with an exclusive streaming contract), who cut ties with company and alleged that it owed him $3 million;
• None of the artists signed with TIDAL would have any legal obligation to stay with the platform after a merger;
• TIDAL was the subject of an ongoing criminal fraud investigation by the government of Norway (where the company initially was created) for artificially inflating its streaming numbers; and
• Dorsey was the sole Block management member who was in favor of the acquisition proposal.

Business judgment review. The court stressed that a business decision by a board comprised of independent and disinterested directors is entitled to review under the deferential business judgment rule unless the directors acted in bad faith. The court wrote: “[A] board comprised of a majority of disinterested and independent directors is free to make a terrible business decision without any meaningful threat of liability, so long as the directors approve the action in good faith.”

Negative view of the Transaction Committee’s process. Although the court stressed that the Committee was entitled to judicial deference to its business decision, the court’s recitation of the background facts indicated its negative view of the transaction process. The court noted the following:

• The Committee had three formal meetings, the first lasting 35 minutes, the second lasting one hour; and the third, which occurred more than two months after the second, lasting one hour.
• The day before the first meeting was the first time that management informed the Committee that Dorsey, before the Committee was formed and without board authorization, had submitted a letter of intent to TIDAL a month earlier (for a purchase price of almost $555 million).
• The Committee did not receive management’s valuation of the transaction prior to its first meeting.
• Four days before the Committee’s second meeting, management provided the Committee (for the first time) with a report that informed the Committee about TIDAL’s financial and other problems. In the report, management set an expected purchase price of $550-$750 million. At the meeting, in response to a questionnaire from the Committee, management informed the Committee that senior managers (other than Dorsey) were against the deal; that TIDAL artists had no legal commitment to maintain their relationship with the platform following a merger; and that management did not have a detailed plan for assimilating and building the business.
• The day after the second meeting, the Committee updated the full board at the board’s regular meeting—with the update being one of fourteen items of business discussed at the meeting.
• A few days after Block and TIDAL agreed on a term sheet for the acquisition, Dorsey and Carter “were spotted vacationing together in Hawaii.”
• At the third meeting, based on further negative information, Block’s management reduced its valuation of TIDAL to $350 million—after predicting that the acquisition would generate negative EBITDA for Block of $35.6 million in 2021, $55 million in 2022, and $68.3 million in 2023. In response to new questions from the Committee, management again responded that artists would not be legally obligated to continue with the platform and stated that, if they did so, it would be based only on the influence of Carter and Dorsey.
• Management’s presentation at the third meeting “set forth the acquisition as more of an assumption than an open question.” (Management told the Committee that the Committee would be “update[d] once the Committee had “finalized terms we are comfortable with.”)
• The Committee then “went dark” for three months while Dorsey negotiated the purchase price. The Committee then approved the acquisition by unanimous written consent, “without any further meetings.”

What constitutes bad faith. The Chancellor noted that Delaware law does not provide an exhaustive definition of “bad faith.” The Delaware Supreme Court has described a “non-exhaustive set of circumstances” that constitute a failure to act in good faith: “where the fiduciary intentionally acts with a purpose other than that of advancing the best interests of the corporation, where the fiduciary acts with the intent to violate applicable positive law, or where the fiduciary intentionally fails to act in the face of a known duty to act, demonstrating a conscious disregard for his duties.” The Supreme Court stated that “there may be other examples of bad faith yet to be proven or alleged, but these three are the most salient.” The Chancellor noted that pleading a failure to act in good faith “requires the plaintiff to plead particularized facts that demonstrate that directors acted with scienter, i.e., that they had actual or constructive knowledge that their conduct was legally improper. That is,…that the actor knew he was acting inconsistent with his fiduciary duties.”

The Disney example of bad faith. The court acknowledged that some business decisions are so suspect as to make it reasonably conceivable that the decision-makers were not acting to advance the best interests of the corporation and thus may have been acting in bad faith. The court cited Disney (affirmed by the Delaware Supreme Court in 2006) as an example. In that case, the stockholder-plaintiff sued Eisner (Disney’s departing CEO) and the Disney board for breach of fiduciary duties in connection with the hiring and firing of Eisner’s longtime friend (Ovitz) as President. Based on the board’s “stark” lack of involvement in the hiring decision, as well as the board’s approval, without any prior investigation, of exit terms very favorable to Ovitz that Eisner negotiated with him when Eisner terminated him just a year after he was hired, the court found it reasonably conceivable that the directors had “consciously and intentionally disregarded their responsibilities, adopting a ‘we don’t care’…attitude concerning a material corporate decision.” That “ostrich-like approach” fell outside the protection of the business judgment rule.

McElrath distinguished. By contrast, the court noted, in McElrath (affirmed by the Delaware Supreme Court in 2020), the stockholder-plaintiff challenged Uber’s acquisition of a self-driving car project from Google, which had been negotiated by Uber’s CEO (Kalanick). Uber’s due diligence materials included a report from a computer forensic investigation firm finding that certain Google employees had retained confidential information from Google following their departure. When misuse of that confidential information later was revealed, Uber suffered financially and reputationally. The plaintiff pled bad faith by the Uber board on the theory that the directors were on notice that Kalanick might ignore intellectual property issues because: his prior business had been sued for copyright violations; Uber allegedly had a practice of hiring employees from competitors to steal trade secrets; and the merger agreement had an unusual indemnification provision that prevented Uber from seeking indemnification from the target’s employees for non-compete and infringement claims. The court found that although the board had approved what was by any measure a “flawed” transaction, the board “had done more than just rubberstamp the deal.” The board met to consider the transaction, enlisted the assistance of outside counsel, “heard a presentation summarizing the transaction, reviewed the risk of litigation with Google, discussed due diligence, and asked questions.” Therefore, the business judgment rule applied.

Harris v. Junger distinguished. The court noted the recent Harris v. Junger transcript decision (Apr. 3, 2023), where the court found that an independent board may have acted in bad faith. That case, the court stated, was distinguishable from Block because the directors in that case could not articulate a business rationale for the challenged transaction (which had the effect of providing the company’s controller with perpetual control while the company received no consideration in return)—while, in Block, “documents incorporated by reference into the Complaint reflect[ed] that the [Block] Board identified the expansion into the music industry as a benefit to Block.” The court stated in Harris that, “as sort of a base-line proposition, identifying the benefits to the company accorded by a board-approved transaction should not be particularly difficult….”

The Transaction Committee’s good faith. The Block plaintiff acknowledged that the Committee asked “many questions throughout the process,” but argued that the problem was that “the answers did not seem to matter.” When asked if senior management supported the deal, the answer was that only Dorsey supported it; when asked whether artists would be bound post-merger, the answer was that they would not; when asked for near- and long-term plans for integrating TIDAL, the answer was that there were none (and that this presented a big risk). However, the court viewed the plaintiff’s argument as effectively asking the court “to presume bad faith based on the merits of the deal alone.” The court observed that the plaintiff did not allege that the Committee lacked a business reason for wanting to acquire, nor that any of the Committee members were beholden to Dorsey in any way. Also, the plaintiff acknowledged that the Committee “did not sit idly by while Dorsey presented”—rather, the Committee asked “many appropriate questions,” asked follow-up questions, and received more than twenty single-spaced slides providing management’s detailed answers to these questions. The court also noted that, over the course of the negotiations, “the purchase price dropped considerably.” On these facts, the court concluded that the Committee’s actions more closely resembled those in McElrath than in Disney or Harris.

Observations. We would note two factors that would tend to support a view that the decision may not have been a “terrible business decision” when made. First, Dorsey, who currently owns roughly 10% of Block, likely had a very large personal financial stake in the acquisition—which would seem to indicate that, although he may have been motivated in part by his friendship with Carter, he likely believed that the acquisition was in the best interests of Block and its stockholders. Second, as the court briefly noted, the purchase price dropped considerably over the course of the negotiations. Specifically, during the summer of 2020 (before the Block board process with respect to a transaction was underway), Dorsey had sent a letter of intent to TIDAL proposing an acquisition of the company for $555 million. In October 2020, management reduced its total enterprise valuation of TIDAL to $490 million; in January 2021, management reduced it to $350; and, in November 2021, Block disclosed in its public filings that, after adjustments, it ultimately paid $237.3 million for a stake of 86.23%, implying an enterprise valuation of about $275 million. The price decreases appear to suggest that TIDAL’s problems and the deal risks were being taken into account.

Practice Points

• Boards and special committees. A board or special committee cannot essentially do almost nothing or adopt an “ostrich-like” approach. Block serves as a reminder that a board or special committee should: carefully evaluate a transaction (as well as alternatives, including no transaction) before approving it; meet an appropriate number of times for an appropriate length of time; receive a presentation from management (and, if appropriate, others) that summarizes all material aspects of the transaction; ask questions of management (and, if appropriate, others), including follow-up questions; consider the responses it receives to its questions; and understand, and be able to articulate, the business rationale for the transaction. Further, a board should establish a careful record (for example, in minutes of meetings) reflecting its deliberations and actions in connection with the transaction. Additional protection for a board or committee is afforded by the engagement of independent and experienced advisors and obtaining a fairness opinion.
• Management. The decision serves as a reminder that management should: not engage in discussions with a target except as authorized by the board; report to the board material contacts with the target and other material developments in the process; provide appropriate information to the board about the target and the transaction; respond in reasonable detail to the board’s questions; and not consider a transaction as a fait accompli while the process is ongoing.