Delaware Supreme Court Holds That Plaintiffs Seeking Monetary Damages Must Plead Non-Exculpated Claims Against Disinterested Directors to Survive Motion to Dismiss by Those Directors
In a decision1 issued on May 14, 2015, the Delaware Supreme Court held that a plaintiff seeking only monetary damages against a director who is protected by an exculpatory charter provision must plead duty of loyalty/bad faith claims to survive a motion to dismiss, regardless of the underlying standard of review for the board’s conduct (whether Revlon,2 Unocal,3 entire fairness or business judgment) and regardless of whether the transaction is an interested transaction. In so holding, the Delaware Supreme Court reversed the Chancery Court decisions in In re Cornerstone Therapeutics Inc. Stockholder Litigation4 and In re Zhongpin Inc. Stockholders Litigation,5 in which the Chancery Court reluctantly held that Delaware Supreme Court precedent required that all directors remain defendants until the end of litigation if a plaintiff states a non-exculpated claim against interested parties in connection with a transaction subject to entire fairness review, and remanded the cases to the Chancery Court to determine whether the plaintiffs had sufficiently pled non-exculpated claims of breaches of fiduciary duty against the independent directors to survive a motion to dismiss.
The Delaware Supreme Court’s ruling in Cornerstone affirms that giving all claims against directors a free pass at the pleading stage in an interested party transaction would be tantamount to a holding that all directors are presumed disloyal until proven otherwise. The Court noted that this has never been Delaware law and that as a practical matter, such a holding would impose disincentives on board service. The decision will provide independent, disinterested directors who can avail themselves of charter exculpation provisions with added protection against protracted and costly litigation involving a controlling stockholder and remove from plaintiffs at the outset of a case a potential insurance settlement pool, particularly in cases where the transaction is subject to entire fairness review.
The Delaware Supreme Court’s decision addressed two separate decisions issued by the Delaware Chancery Court. In each, the merger (at a substantial premium to the pre-announcement market price) was negotiated by a special committee of disinterested directors and approved by a majority of the minority of stockholders. In both cases, however, the board did not follow the predicate procedural safe harbor established by Khan v. M&F Worldwide Corporation6 needed to shift the standard of review of the board’s decision from entire fairness to business judgment: (i) an up-front, unwaivable majority of the minority stockholder vote and (ii) a well-functioning special committee. In both cases, the plaintiffs failed to state specifically claims that the disinterested directors had breached their duty of loyalty. In denying the motions to dismiss in each case, the Chancery Court questioned the merits of forcing all directors to remain in the litigation for the duration where they were entitled to exculpation through company charter clauses established under Section 102(b)(7) of the DGCL, but held that under the Delaware Supreme Court’s decision in Emerald Partners v. Berlin7 it could only determine the directors’ exculpation from monetary damages under entire fairness review on a fully developed factual record. The Chancery Court in each case recommended certification of an interlocutory appeal to the Delaware Supreme Court to determine the correctness of its interpretation of precedent.
THE SUPREME COURT’S DECISION
Acknowledging the potential ambiguity of its prior decisions, the Delaware Supreme Court held in Cornerstone that, regardless of the underlying standard of review for a transaction, plaintiffs must plead a non-exculpated breach of fiduciary duty claim against an independent director protected by an exculpatory charter provision or the director is entitled to be dismissed from the litigation. Specifically, a plaintiff must plead facts “supporting a rational inference that the director harbored self-interest adverse to the stockholders’ interests, acted to advance the self-interest of an interested party from whom they could not be presumed to act independently, or acted in bad faith.”8
In so holding, the Court rejected the plaintiffs’ argument that there should be an automatic inference that a director facilitating an interested transaction is disloyal because of a heightened possibility of conflicted loyalties and because facts giving rise to a duty of loyalty breach may be unknowable at the pleading stage. The Court noted that such an automatic inference would be inconsistent with Delaware law and would increase costs for directors, corporations, and stockholders without a corresponding benefit.
The Court emphasized that under Delaware jurisprudence each director has a right to be considered individually when he or she faces claims for damages in a suit challenging board action.That individualized consideration “does not start with the assumption that each director was disloyal” but rather that independent directors are “presumed to be motivated to do their duty with fidelity.”9
Moreover, the Court observed that in practice the plaintiffs’ approach likely would create more harm than benefits for minority stockholders. The Court noted that it would not want to adopt a rule that would disincentivize directors from serving on special committees or incentivize directors to reject transactions solely because their role in negotiating on behalf of stockholders would cause them to remain as defendants until the end of any litigation challenging the transaction. The Court pointed out that it was precisely the fear of dissuading directors from making decisions favoring stockholders that led to the adoption of the exculpatory Section 102(b)(7) of the DGCL.
The Court clarified that its decision in Emerald Partners, which the Chancery Court had misinterpreted, was focused on a different question than the one at issue, namely whether courts could consider the effect of a Section 102(b)(7) provision before trial when the plaintiffs have pled facts supporting an inference that each director breached his or her duty of loyalty as well as his or her duty of care, when the applicable standard of review of the underlying transaction is entire fairness. In such a situation, the Court said, the substantive fairness inquiry would shed light on why the directors acted as they did. Such a standard did not answer the question at issue in Cornerstone and Zhongpin — whether the application of entire fairness review requires a court to deny a motion to dismiss by independent directors when the plaintiffs have not sufficiently pled a non-exculpated claim against those directors.
The Supreme Court concluded that where the plaintiffs have not pled any facts to support an inference that independent directors breached their duty of loyalty, “fidelity to the purpose of Section 102(b)(7) requires dismissal of the complaint against those directors.”10