Delaware Supreme Court Provides New Guidance for Directors and Officers Evaluating a Corporate Sale or Restructuring

A recent decision by the Delaware Supreme Court, Gantler v. Stephens, C.A. No. 2392 (Del. January 27, 2009) (available here) provides new guidance for directors and officers on their fiduciary duties arising in connection with a possible corporate sale or restructuring. In Gantler, the Court held that directors and officers of an Ohio bank (the “Bank”) could be found to have breached their fiduciary duty by rejecting an opportunity to sell the Bank and instead pursuing a recapitalization that favored the insiders. The case was brought by a former director (Gantler) and minority shareholders of First Niles Financial, Inc. (“First Niles”), the Bank’s holding company.



In short, the historical position under Delaware corporate law has been that certain conflicts of interest of insiders (such as trying to keep one’s employment or directorship) are inherent and unavoidable, and if properly disclosed, would not result in a higher level of scrutiny from courts over board decisions. Gantler holds that this is not always true, and that specific facts can alter that position.



Specifically, where directors and/or officers are -- or with 20/20 hindsight, may be argued to be -- motivated to prefer one particular transaction over another, even if the motivation is reasonable and disclosed to shareholders, extreme care should be taken to ensure that the board evaluation and deliberation process is balanced and well-documented. Failure to do so may prevent a board from being entitled to the business judgment rule and subject the directors and officers to a stricter standard that the actions meet the “entire fairness” test under Delaware law.



After a strong acquisition market, in August 2004, the First Niles board agreed to put the Bank up for sale and hired investment bankers to pursue the opportunity. Shortly thereafter, the managing officers of First Niles (and the Bank), several of whom were also directors, advocated that the Bank abandon the process and privatize the company by delisting from the NASDAQ SmallCap Market. The Bank received offers from three strategic purchasers, each considered by the bankers to be within the recommended range. Two offers made clear that the purchaser would terminate the incumbent First Niles board upon closing. In the months that followed, management did not respond to the bidders’ due diligence requests and delayed the process (resulting in the withdrawal of one bid, which was not disclosed to the board until after the fact) and continued to discuss the privatization proposal. In March 2005, notwithstanding a favorable opinion from the bankers as to one of the offers, the board voted 4 to 1 to reject the offer, with Gantler being the only dissenting vote, and turned its attention to the privatization plan.



In April 2005, management presented to the board its privatization proposal, which would reclassify the First Niles common stock held by holders of 300 or fewer shares into a new class of Series A Preferred Stock that would pay higher dividends and have the same liquidation preference as the common stock, but that would not have voting rights except in the event of a proposed sale of the company. In December 2005, the proposal was approved 3 to 1 by the Board, with Gantler again being the only dissenting vote. Shortly thereafter, Gantler was replaced on the Board by an officer of the company. The following June, the newly-composed First Niles Board unanimously approved a charter amendment to effect the reclassification and proceeded with the proxy solicitation process for shareholder approval. The proxy statement did disclose that the directors and officers had a conflict of interest with respect to the reclassification and the alternative transactions that the board had considered, including a business combination that was turned down.



Following shareholder approval of the charter amendment, the plaintiffs brought suit in the Delaware Chancery Court alleging, among other things, that the board violated its various fiduciary duties by sabotaging due diligence and abandoning the sales process in favor of their own incumbency. In March 2008, the Chancery Court dismissed the case for failure to state a claim and the parties appealed.




In reversing the Chancery Court’s dismissal, the Supreme Court clarified several issues of Delaware corporate law, including the following:



§ Higher Scrutiny for Transactions with Potential Conflict of Interest. The Court agreed with the defendants that the Board’s duty in this case should be analyzed under the more favorable business judgment rule, as opposed to the “enhanced scrutiny” standard under Unocal.



However, the Court did hold that the business judgment presumption could be rebutted in this case because reasonable inferences of self interest could be drawn from the defendant directors’ and officers’ lack of cooperation with the due diligence requests and sabotaging of the bid process. In its analysis, the Court highlighted the specific conflicts arising from a sale of the Bank for each of the directors -- the potential loss of employment for the Chairman/CEO; and the loss of the Bank as a key client for businesses operated by two different directors. It is also interesting to note that the Court relied on the disclosure in the proxy statement of the potential for conflict of interest as an admission that the conflict did in fact exist.



There can be little question that the extreme facts of this case heavily influenced the Court’s decision to rebut the presumption of good faith by the board, and that the outcome may have been different if the some of the “sabotaging” activity was not present and if the board deliberations regarding the sale proposals were more extensive. The Court specifically noted that after only one bidder remained and the bankers opined that the bidder may continue to improve their offer, the board did not discuss the offer at one meeting and rejected in another, “without discussion or deliberation.”



If directors or officers do have personal financial interests that diverge from the interests of other shareholders, a board should now be prepared for a higher standard of review of their actions. That said, Gantler should not be read to require a board to reach any particular decision (e.g. sell, recapitalize, etc.), but only that the process to reach that decision is fair and informed. Therefore, to the extent that certain opportunities can later be reasonably argued to have been more preferable for certain (minority) shareholders, boards should be advised to more carefully evaluate those opportunities and to document why they may not have been in the best interests of all shareholders.



Where a potential conflict does exist, boards should be advised to consider the appointment of an independent committee for the M&A process, where such committee would have the authority to engage its own advisors and independent legal counsel. Another approach may be to engage multiple investment banking advisors to provide a board with a comparative analysis of the opportunities. Finally, extreme care should be take to distribute all studies, reports and materials in advance of board meetings, to have substantive discussions on those issues at the meetings and properly memorialize in the minutes to evidence that the board fulfilled its duty of care (which it would seem was not met in Gantler).



§ Fiduciary Duty of Officers equal to that of Directors. As an issue of first impression, the Court held that officers of a Delaware corporation have the same fiduciary duties as directors. While this position has been implied, the Supreme Court has now explicitly held that officers owe fiduciary duties of care and loyalty that are the same as those of directors of Delaware corporations.



§ Shareholder Ratification Limited. The Court also disagreed with the Chancery Court’s finding that the shareholder approval of the privatization plan, as submitted by the First Niles board and described in the proxy, “ratified” the prior actions of the board, absolving them of liability. To clarify this area of the law, the Court imposed a number of specific limitations on this doctrine.



First, shareholder ratification is effective only where a “fully informed shareholder vote approves director action that does not legally require shareholder approval in order to become more legally effective.” Therefore, where a shareholder vote is otherwise required – such as for the approval of a charter amendment or a merger – the shareholder vote does not carry any ratifying effect of the preceding board action.



Second, the only director action that can be ratified is that which shareholders are specifically asked to approve. For example, the ultimate approval of a merger by shareholders does not mean that shareholders have also ratified all related director actions, such as defensive measures that may have been taken in the context of that transaction.



Third, the effect of shareholder ratification does not extinguish all claims in respect of the ratified director action, but rather subjects the challenged action to business judgment review (as opposed to the entire fairness test). Therefore, companies should not assume that a valid shareholder vote would sanitize the prior actions of a board in connection with any particular corporate decision or transaction.

Delaware Supreme Court denies standing to directors to bring derivative action

A recent Delaware Supreme Court decision rules that directors who are not otherwise shareholders of a corporation do not have standing to bring a derivative claim on behalf of the corporation.

The case involved claims by the plaintiff director that the other directors of the corporation were controlled by a single shareholder, who was also the corporation's CEO and Chairman. The Court held that such standing was not expressly provided by the Delaware statute, and refused to judicially extend such standing pursuant to equitable doctrine.

The decision discusses commentary from the ALI (American Law Institute) specifically recommends that such standing be extended to directors. The Court refuses to adopt this standard in Delaware, while noting that the ALI proposal has only been adopted in one state, Pennsylvania. The Court also referenced the New York corporate statute as being unique in providing directors with a statutory right to sue other directors of the corporation. (I guess that's another reason not to incorporate in New York, if you need one).

Action by Written Consent Challenged by Court

Lawyers often say that bad facts make bad law. Until the recent passage of the corporate statute for Massachusetts under Chapter 156D, corporate lawyers in Massachusetts would often shy away from incorporating in Massachusetts because of the various statutory limitations and the lack of case law to help interpret corporate conduct. One key issue, one seemingly resolved in the new 156D, was the requirement in the old law that all stockholders must sign a written consent. With clients and investors spread around the world, and often traveling, this requirement delayed many a closing and created other issues. The new statute provides an opt-in procedure for a charter provision to permit the majority to act by written consent in lieu of a meeting. While most practitioners still see this format as being inferior to that in Delaware - where this is the default from which you need to opt out – it is still a major improvement.

A recent decision by a Massachusetts Superior Court involving a renewable energy start-up called Current to Current Corporation (C2C) places this provision in doubt and creates ambiguity around the process of removing directors by written consent.

In Peak Ventures, Inc. v. Manfred Kuehnle et al, Mass. Sup. CV 07-3772 (Gants, J., Aug. 24, 2007), the controlling stockholder group (including the company’s founder, CEO and chairman) sought to remove independent directors from the Board after they accused the CEO, Mr. Kuehnle, of self-dealing and sought to remove him from the Board. The complaint alleges that he failed to disclose the company’s grave financial position to the Board and excluded them from the fundraising process, driving the company into insolvency and into deep debts. The plaintiffs (the other board members who were also minority investors and option holders) upon learning of the alleged wrongdoing, noticed a meeting to remove the CEO from office and to take other emergency action. The CEO asked to delay the meeting, while taking action by written consent to amend the bylaws to give the stockholders additional control over key corporate decisions and to remove the independent directors from the Board and appoint two new directors that plaintiffs claimed to be “loyal” to the CEO. The bylaws for the company followed the 156D statutory language to allow actions by less than unanimous written consent and expressly provided that a “[c]onsent signed under this Section has the effect of a vote at a meeting.”

With the action to take effect on seven days from the notice, the plaintiffs sought a TRO to prevent the effect of the consent action to restructure the Board. The Court agreed with them in part, ruling that removal of directors without a meeting is a special circumstance that requires a live stockholder meeting. Say what? The order does not cite any case law in support of this decision, nor is there any in the plaintiffs motion for TRO. The court held that the specific requirement for a meeting before a director is removed “overrides the more general authorization in 156D, s 7.04 for shareholder actions to be conducted without a meeting." The court reasoned that “this exception reflects the Legislature’s recognition that, when a director is to be removed, the reasons for such removal should be aired at a meeting, which may not occur if the majority of shareholders are permitted to act without such a meeting through a Consent.”

This decision is troubling for many reasons. Getting entrepreneurs to think about corporate governance issues and to bring on independent directors at an early stage is difficult enough. Decisions like Peak Ventures are only likely to scare founders away from bringing others into their decision-making process, leaving young companies without an experienced sounding board for their decisions. Considering that many venture investors will seek board representation and will ask to add industry experts as independents to the board, founding stockholders would be well-advised to increase the board size to still retain majority of the board. Here the board consisted of 5 directors; now it would seem that 7 or 9 may be the right number – making meetings harder to schedule and conduct.

For practitioners, this decision poses an interesting opinion issue. Since most startups don’t hold formal shareholder meetings and make most, if not all, decisions by written consent, the election of directors on which one relies for providing a corporate authorization representation and opinion could now be placed in doubt. In light of this decision, diligencing for opinion may now include a closer examination of written consents vs. meeting minutes.

Delaware Supreme Court rejects theory that creditors may directly sue Boards of insolvent corporations for breach of fiduciary duty

A strong decision last week by the Delaware Supreme Court, NACEPF v. Gheewalla et al., protecting the boards of insolvent companies from creditor claims, may be another significant reason to incorporate in Delaware.

"Zone of insolvency"... Ahh. Makes me wistfully think back to the days of F*ckedCompany.com, circa 2002, sitting in scores of board meetings of companies that were soon to meet their maker. You all know the typical scenario. Company X raises %10-15M of venture capital in one or more rounds, market adoption slows and investors decide that another investment is probably not prudent. So they gently get out of the way, letting the management know that they won't lead the next round but would follow another lead. Burn rate is at a pretty good pace, and management ignores the VC body language, assuming that the cache of their past investors will help find new ones quickly, and that a follow is just as good anyway.

When things don't work as planned, and cash starts to get real tight, a board meeting is called where a new lawyer from your corporate law firm appears - their bankruptcy guy - and tells you that you probably need to shut the company down, or face potential claims from creditors because you are now in the "zone of insolvency". What is that, you say? Well, generally, the "zone" is when a company cannot pay its debts when they become due, such as payroll or vendor payables, etc. So now, he claims, you will face claims from creditors who don't get paid unless you shut the company down now, while there is still money left to pay. You shrug because that state probably describes the company from day one, so that just cannot be case. Otherwise, how do companies get started?

Unfortunately, this issue has plagued startups for the last decade, and probably has resulted in a good share of startups being shut down, when they may have made it in the end. Last week, the Delaware Supreme Court put an end to the dilemma by holding, in no uncertain terms, that "the creditors of a Delaware corporation that is either insolvent or in the zone of insolvency have no right, as a matter of law, to assert direct claims for breach of fiduciary duty against the corporation’s directors."

The Court agreed with the Chancery Court in its reasoning that “an otherwise solvent corporation operating in the zone of insolvency is one in most need of effective and proactive leadership—as well as the ability to negotiate in good faith with its creditors—goals which would likely be significantly undermined by the prospect of individual liability arising from the pursuit of direct claims by creditors.”

Because this has been such an important issue for academics and practioners alike, the Court noted that "the need for providing directors with definitive guidance compels us to hold that no direct claim for breach of fiduciary duties may be asserted by the creditors of a solvent corporation that is operating in the zone of insolvency. " When a solvent corporation is navigating in the zone of insolvency, the Court emphasized that the focus for Delaware directors does not change: " directors must continue to discharge their fiduciary duties to the corporation and its shareholders by exercising their business judgment in the best interests of the corporation for the benefit of its shareholder owners."

It is important to note that this decision does not completely eliminate Board liability for any claims, but just those claims that are "direct" claims brought by the creditors. In general, claims against a Board can be direct or derivative, depending on a myriad of factors, including how and to whom the harm occurs. A derivative claim is a claim brought by the corporation that has suffered from the misconduct of directors, and typically must be reviewed by an independent committee as to whether the claim is a valid one. Therefore, while the NACEPF decision does leave room for creditors to bring derivative claims, the risk is diminished that the threat of such an action would chill board members from continuing to serve and from making hard decisions in distressed circumstances.