The Delaware Law Series

Material Adverse Effect Clauses and the COVID-19 Pandemic

Robert T. Miller is a Professor of Law at the University of Iowa College of Law. This post is based on his recent paper. Related research from the Program on Corporate Governance includes Allocating Risk Through Contract: Evidence from M&A and Policy Implications by John C. Coates, IV (discussed on the Forum here) and The New Look of Deal Protection by Fernan Restrepo and Guhan Subramanian (discussed on the Forum here).

In a working paper just posted on SSRN, I consider whether the COVID-19 pandemic, the governmental responses thereto, and a company’s actions taken in reaction to both of these are likely to constitute a “Material Adverse Effect” (MAE) within the meaning of a typical MAE clause in a public company merger agreement. In addition to the conclusions about COVID-19 and MAEs summarized below, the paper also reviews important Delaware caselaw on MAEs, identifies open problems in those cases, and suggests a more comprehensive theory of MAEs that rationalizes the caselaw and solves most of the open problems.

As to COVID-19 and MAEs, although in any particular case everything will depend on the exact effects on the company and the precise wording of the MAE clause, nevertheless because MAE definitions tend to follow common patterns, some general conclusions about typical MAE clauses are warranted, including the following:


Three Is Not A Trend: Another Caremark Claim Survives A Motion To Dismiss, But Does Not Reflect A Change In The Law

Nicholas D. Mozal is counsel and David Seal is an associate at Potter Anderson & Corroon LLP. This post is based on their Potter Anderson memorandum and is part of the Delaware law series; links to other posts in the series are available here. Related research from the Program on Corporate Governance includes Monetary Liability for Breach of the Duty of Care? by Holger Spamann (discussed on the Forum here).

The Delaware Court of Chancery recently denied another motion to dismiss a Caremark claim in Hughes v. Hu. [1] Under In re Caremark International Inc. Derivative Litigation, [2] directors have a duty to exercise oversight and monitor a corporation’s operational viability, legal compliance, and financial performance and reporting. Hughes is now the second decision, after In re Clovis Oncology, Inc. Derivative Litigation, [3] to allow a Caremark claim to proceed beyond the pleadings stage since the Delaware Supreme Court reversed the Court of Chancery’s dismissal of a Caremark claim in Marchand v. Barnhill. [4] It would be a mistake, however, to read Hughes as an extension of those decisions and only in that context. Indeed, Hughes understandably does not even cite Clovis. The better reading is that Hughes, like the Court of Chancery’s 2013 decisions in Rich v. Yu Kwai Chong [5] and In re China Agritech, Inc. Shareholder Derivative Litigation, [6] reflects the particular accounting and oversight difficulties witnessed in certain Chinese businesses that have gained access to the United States capital markets through a reverse merger. In short, the actions of the audit committee in Hughes are in no way analogous to how the vast majority of audit committees and their advisors operate to ensure a board fulfills its Caremark duties by exercising appropriate oversight. Nevertheless, Hughes reiterates the reasons why it is important for boards and committees to continue adhering to those best practices. In addition, Hughes addresses the importance of maintaining proper records and indicates how those records may be useful in responding to stockholder demands for books and records pursuant to 8 Del. C. § 220.


Board Oversight in Light of COVID-19 and Recent Delaware Decisions

Holly J. Gregory is partner, Thomas A. Cole is senior counsel, and Claire H. Holland is special counsel at Sidley Austin LLP. This post is based on a Sidley memorandum by Ms. Gregory, Mr. Cole, Ms. Holland, Sharon R. Flanagan, Sara B. Brody. This post is part of the Delaware law series; links to other posts in the series are available here. Related research from the Program on Corporate Governance includes Monetary Liability for Breach of the Duty of Care? by Holger Spamann (discussed on the Forum here).

In times of crisis, the risk of shareholder derivative litigation rises as boards of directors face heightened scrutiny of their actions. While business judgment protection applies to good faith board efforts to navigate a crisis, boards and their advisors should be mindful of guidance that the Delaware courts have issued in the past year, including in a Delaware Chancery Court case decided on April 27, regarding the circumstances in which a claim can move forward seeking to hold directors personally liable for a failure of oversight.

The 1996 Delaware Chancery Court decision in In re Caremark Int’l Inc. Deriv. Litig. clarified that directors are responsible for overseeing that the company has in place information and reporting systems reasonably designed to provide the board and senior management with timely, accurate information sufficient to support informed judgments about compliance risk. [1] Since then, shareholder plaintiffs have tried to hold directors liable for a variety of corporate missteps on the basis that directors failed in their oversight role. These claims—known as Caremark claims—have until recently typically been dismissed in early pleading stages (before discovery) for failure to state a claim. Indeed, these types of claims are regarded as among the most difficult on which to establish director liability (although Caremark claims survived motions to dismiss in a few rare cases prior to 2019). [2] Nonetheless they are attractive to plaintiffs because an oversight failure sufficient for a Caremark claim constitutes a breach of the duty of loyalty and good faith which cannot be exculpated under Delaware law. Because most Delaware corporations provide in their charters that directors will not be held personally liable for breaches of the duty of care, this is one of the few remaining avenues to seek monetary damages from directors personally absent a conflict of interest situation.


Recent Delaware Court of Chancery Decision Sustains Another Caremark Claim at the Pleading Stage

Meredith Kotler and Pamela Marcogliese are partners and Marques Tracy is an associate at Freshfields Bruckhaus Deringer LLP. This post is based on their Freshfields memorandum and is part of the Delaware law series; links to other posts in the series are available here. Related research from the Program on Corporate Governance includes Monetary Liability for Breach of the Duty of Care? by Holger Spamann (discussed on the Forum here).

After decades of routinely dismissing such claims, Vice Chancellor Laster’s recent 41-page decision in Hughes v. Hu represents the third time since the Delaware Supreme Court’s decision last year in Marchand v. Barnhill that the Court of Chancery has sustained a Caremark duty of oversight claim at the pleading stage. It remains unlikely that these recent decisions signal some change in the law, but rather reflect allegations of unique or extreme examples of certain corporate behavior. That said, these cases serve as a reminder of the importance of active, engaged board oversight of “mission critical” risk and compliance issues, and boards should take proactive steps to ensure that directors do not face personal liability for a failure of oversight.

Marchand, Clovis, and Inter-Marketing Group

Caremark claims, which allege failures of board oversight, have long been regarded by Delaware courts as “possibly the most difficult theory in corporation law upon which a plaintiff might hope to win a judgment.” To plead and prove a Caremark claim, a stockholder plaintiff must show that the board either (i) “utterly failed to implement any reporting information restrictions or controls”; or (ii) having implemented them, “consciously failed to monitor or oversee their operations, thus disabling themselves from being informed of risks or problems requiring their attention.” Not surprisingly, these claims routinely fail at the pleading stage.


Standards of Review Applicable to Board Decisions in Delaware M&A Transactions

Robert B. Little is a partner and Steve J. Wright and Kiel Sauerman are associates at Gibson, Dunn & Crutcher LLP. This post is based on their Gibson Dunn memorandum and is part of the Delaware law series; links to other posts in the series are available here.

M&A practitioners are well aware of the several standards of review applied by Delaware courts in evaluating whether directors have complied with their fiduciary duties in the context of M&A transactions. Because the standard applied will often have a significant effect on the outcome of such evaluation, establishing processes to secure a more favorable standard of review is a significant part of Delaware M&A practice. The chart below identifies fact patterns common to Delaware M&A and provides a preliminary assessment of the likely standard of review applicable to transactions fitting such fact patterns. However, because the Delaware courts evaluate each transaction in light of the transaction’s particular set of facts and circumstances, and due to the evolving nature of the law in this area, this chart should not be treated as a definitive statement of the standard of review applicable to any particular transaction.


Citing Thin Board Record: Delaware Court of Chancery Again Sustains Oversight Claim

William SavittRyan A. McLeod and Anitha Reddy are partners at Wachtell, Lipton, Rosen & Katz. This post is based on their Wachtell memorandum and is part of the Delaware law series; links to other posts in the series are available here. Related research from the Program on Corporate Governance includes Monetary Liability for Breach of the Duty of Care? by Holger Spamann (discussed on the Forum here).

The Delaware Court of Chancery has sustained another Caremark claim, pointing to the absence of documents produced in response to a stockholder’s inspection demand as evidence that the directors “face a substantial likelihood of liability” for “failing to act in good faith to maintain a board-level system for monitoring the Company’s financial reporting.” Hughes v. Hu, C.A. No. 2019-0112-JTL (Del. Ch. Apr. 27, 2020).

The case involved Kandi Technologies, a Delaware corporation headquartered in China that sells automobile parts. Kandi had a long history of inadequate internal controls, including improper insider transactions and a 2017 restatement of earnings. The stockholder plaintiff complained that the board failed to implement responsible auditing protocols notwithstanding these clear red flags.


Purpose With Meaning: A Practical Way Forward

Robert G. Eccles is Visiting Professor of Management Practice at Oxford University Said Business School, and a Senior Advisor to the Boston Consulting Group; Leo E. Strine, Jr., the former Chief Justice of the Delaware Supreme Court, is the Austin Wakeman Scott Lecturer in Law and Senior Fellow at the Harvard Law School Program on Corporate Governance, as well as Of Counsel at Wachtell, Lipton, Rosen & Katz; and Timothy Youmans is Lead-North America, EOS at Federated Hermes. This post is based on their article published in the Harvard Business Review. Related research from the Program on Corporate Governance includes The Illusory Promise of Stakeholder Governance by Lucian A. Bebchuk and Roberto Tallarita (discussed on the Forum here), and Toward Fair and Sustainable Capitalism by Leo E. Strine, Jr (discussed on the Forum here).

When leading money managers embrace the need for corporations to be socially responsible and the Business Roundtable (BRT) declares that the purpose of a corporation is “to create value for all stakeholders,” it is safe to say that purpose has gone mainstream in the corporate narrative. A consensus is emerging that society and diversified investors are best served by companies that focus on sustainable value creation and respect the legitimate interests of all stakeholders, not just stockholders. But how can these high ideals be put into practice? That corporate employees and host communities have borne the brunt of the economic effects of the current pandemic only underscores the deepening sense that our corporate governance system’s empowerment of the stock market has undermined the fairness of our economy.

If companies and institutional investors are serious about responsible, sustainable wealth creation in a manner fair to all corporate stakeholders, then they must match high-minded rhetoric about purpose with accountability. This will require a new governance form that makes a company’s obligations to fulfill its purpose enforceable.


Lessons From the Future—The First Contested Virtual Annual Meeting

Igor Kirman and Sabastian V. Niles are partners and Natalie S.Y. Wong is an associate at Wachtell, Lipton, Rosen & Katz. This post is based on a Wachtell Lipton memorandum by Mr. Kirman, Mr. Niles, Ms. Wong, Oliver J. Board and Loren Oumarova.

The 2020 proxy season has been anything but routine, with the COVID-19 pandemic and the resulting state shelter-in-place orders requiring many companies to make the shift from physical to virtual annual meetings, and state corporate laws being amended to allow these virtual meetings to occur. Yet we had not seen a virtual annual meeting used in a proxy contest until April 30, 2020, when shareholders of TEGNA Inc. participated in the first election contest conducted at a virtual, rather than physical, annual meeting (all of the company’s twelve nominees were re-elected).

While the concept and technology have existed for several years, virtual annual meetings were slow to become widespread. The trickle that began after Delaware amended its business corporation laws to permit such meetings in 2000 gained steam after 2009, when Intel Corporation hosted the first virtual annual meeting using technology pioneered by Broadridge Financial Solutions. According to Broadridge, the number of virtual annual meetings more than doubled from 93 meetings in 2014 to 187 meetings in 2016, and there have been over 200 virtual annual meetings every year since 2017. This year, in light of the COVID-19 pandemic and lockdown requirements, most public companies are using virtual annual meetings, with a large majority doing so for the first time. Yet companies have been reluctant to use virtual meetings for contested situations, due to the extra complexity of such meetings and the unavailability of a commercial platform to do so.

Some key considerations to take into account when navigating a contested virtual meeting are set forth below:


Director Oversight Duties Amidst COVID-19

Jane D. Goldstein is a partner and Daniel Lim and Kenneth Monroe are associates at Ropes & Gray LLP. This post is based on a Ropes & Gray publication by Ms. Goldstein, Mr. Lim, Mr. Monroe, Paul S. Scrivano, and Peter Welsh, and is part of the Delaware law series; links to other posts in the series are available here. Related research from the Program on Corporate Governance includes Monetary Liability for Breach of the Duty of Care? by Holger Spamann (discussed on the Forum here).

As COVID-19 continues to disrupt every aspect of our lives, companies are taking swift actions to determine and mitigate the risks posed by the new “normal.” Directors have a critical role in helping their companies maneuver through these challenging times. Although management is charged with managing the day-to-day operations of the company, directors are responsible for its oversight and should be mindful of their fiduciary duties in that role.

Directors have a duty of care to make well-informed decisions and a duty of loyalty to act and make decisions in the best interest of the company’s stockholders. Directors are afforded substantial protection against liability for their business decisions, but the widespread and quickly developing risks posed by the COVID-19 pandemic underscore the importance of the board’s active engagement.


Navigating Strategic Alternatives in Distressed Scenarios: Takeaways for Boards

Paul Tiger is a partner and Kelsey MacElroy is an associate at Freshfields Bruckhaus Deringer LLP. This post is based on their Freshfields memorandum.

As the economy continues to experience daily turmoil in the wake of the COVID-19 crisis, it becomes increasingly likely that some companies will feel the need to enter into dilutive financings and downside exits.

This new reality poses heightened challenges for boards and increases the likelihood of litigation, as has occurred in past downturns.

For those not looking to repeat history, here’s a look-back at some of the mis-steps that boards of financially distressed companies have made when seeking financing or considering downside exits while in distress, together with some lessons learned about how boards can get it right during these difficult circumstances.

In each of these situations, insiders came to the rescue of a struggling company. At the time, these insiders thought they were stretching to provide support where no one else would tread.

These insiders viewed themselves as courageously taking on risk to save a bad situation from getting worse. But in hindsight, after the turnarounds had occurred, all that the other equity holders and the courts were able to see were flawed board processes.


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