In a decision jointly resolving two appeals − In re Cornerstone Therapeutics Inc. Stockholder Litigation and Leal v. Meeks − the Delaware Supreme Court clarified seemingly conflicting Delaware case law. The decision sought to answer this question: in an action seeking damages against corporate fiduciaries for entering into an interested transaction that is “presumptively subject to entire fairness review, must the plaintiff plead a non-exculpated claim against the disinterested, independent directors to survive a motion to dismiss by those directors?”
In answering this question, the Delaware Supreme Court announced a new bright-line rule: “A plaintiff seeking only monetary damages must plead non-exculpated claims against a director who is protected by an exculpatory charter provision to survive a motion to dismiss, regardless of the underlying standard of review for the board’s conduct − be it Revlon, Unocal, the entire fairness standard, or the business judgment rule.”
Background: Two appeals with similar factual scenarios
The two appeals involved mostly the same basic factual scenarios. Both were stockholder actions seeking damages based on mergers accomplished with controlling stockholders, which had representatives on the board, and which acquired all the remaining shares in the company that they did not own. In addition, the mergers were “negotiated by special committees of independent directors, were ultimately approved by a majority of the minority stockholders, and were [closed] at substantial premiums to the pre-announcement market price.”
Because in neither instance did the controlling stockholder avail itself of the going-private transaction safe harbor announced last year by the Delaware Supreme Court in Kahn v. M&F Worldwide Corp., the transactions were presumed by the court to be subject to review under the entire fairness standard. Under that standard, the defendant directors and controlling stockholder bear the burden of proving that the transaction was accomplished through a fair process and was completed at a fair price.
The charters of both companies contained a provision exculpating the directors from money damages for breaches of the fiduciary duty of care as permitted by Section 102(b)(7) of the Delaware General Corporate Law. The Court of Chancery denied the defendants’ motions to dismiss because it read the precedent of the Delaware Supreme Court as requiring, notwithstanding any 102(b)(7) provision in the company’s charter, that if “the underlying transaction was subject to the entire fairness standard of review, and the plaintiffs were therefore able to state non-exculpated claims against the interested parties and their affiliates, all of the directors were required to remain defendants until the end of the litigation.”
The competing arguments
The independent directors relied on a 2001 decision from the Delaware Supreme Court in Malpiede v. Townson, which held that in a challenge to the sale of a company governed by Revlon obligations, plaintiffs seeking damages against independent directors who are protected by a Section 102(b)(7) charter provision must plead non-exculpated claims (e.g., claims that the directors acted disloyally or in bad faith) against each director, or face dismissal. The independent directors contended that this rule should govern here as well, notwithstanding that the underlying transaction was subject to the entire fairness standard of review applicable to interested transactions.
In arguing the opposite, plaintiffs relied heavily on a series of Delaware Supreme Court decisions issued from 1998 to 2001 in Emerald Partners v. Berlin, and in particular pointed to the following language from the most recent holding in that case: “When entire fairness is the applicable standard of judicial review, a determination that the director defendants are exculpated from paying money damages can be made only after the basis for their liability has been decided [on a fully-developed record].” On this basis, the plaintiffs argued that they were entitled to an “automatic inference that a director facilitating an interested transaction is disloyal because the possibility of conflicted loyalties is heightened in controller transactions, and the facts that give rise to a duty of loyalty breach may be unknowable at the pleading stage.” Thus, in the plaintiffs’ view, the sufficiency of any asserted loyalty or bad faith claims need not be addressed, and therefore the effect of a 102(b)(7) charter provision is irrelevant at a motion to dismiss stage where the underlying transaction is subject to entire fairness review.
The court clarifies the confusion between the Malpiede and the Emerald Partners cases and announces a clear rule
As an initial matter, the court rejected the plaintiffs’ suggested inference, noting that settled Delaware law demands that each director has a right to be “considered individually when the directors face claims for damages in a suit challenging board action,” which inquiry [generally] begins with “presumptions of independence, and that their acts have been taken in good faith and in the best interests of the corporation.” These presumptions operate despite that a director may serve on the board with a controlling stockholder, or where the controlling stockholder itself is “subject to liability for breach of the duty of loyalty if the transaction was not entirely fair to the minority stockholders.”
As to the apparent conflict between Malpiede and Emerald Partners, the court explained that the conflict, although reasonably divined in the court below and among the parties, was false because the plaintiffs inEmerald Partners had pled non-exculpated claims that were “intertwined” with the duty of care claims; thus, the invocation of the 102(b)(7) provision was premature. For example, the plaintiffs alleged that (1) the affiliated directors improperly had participated in deliberations of the independent directors, (2) the controlling director/stockholder improperly had communicated with the investment advisor and, and (3) the independent directors (i) failed to negotiate an exchange ration, (ii) disregarded the committed process and (iii) failed to seek an updated fairness opinion. The court cautioned that theEmerald Partners decisions must be cabined to the facts of that case and not be read so broadly.
The court then announced the following clear rule regarding a plaintiff’s pleading obligations:
When a director is protected by an exculpatory charter provision, a plaintiff can survive a motion to dismiss by that director defendant by pleading 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. But the mere fact that a plaintiff is able to plead facts supporting the application of the entire fairness standard to the transaction, and can thus state a duty of loyalty claim against the interested fiduciaries, does not relieve the plaintiff of the responsibility to plead a non-exculpated claim against each director who moves for dismissal.
After clarifying the law, the court remanded both cases "to determine if the plaintiffs have sufficiently pled non-exculpatory claims against the independent directors."
Public policies underlying the court’s decision
The court listed several policy-based reasons for its rule:
- “Adopting the plaintiffs’ approach . . . would likely create more harm than benefit for minority stockholders in practice.”
- “For more than a generation, [Delaware] law has recognized that the negotiating efforts of independent directors can help to secure transactions with controlling stockholders that are favorable to the minority.”
- “[R]espected scholars have found evidence that interested transactions subject to special committee approval are often priced on terms that are attractive to minority stockholders.”
- Plaintiffs’ suggested rule “would create incentives for independent directors to avoid serving as special committee members, or to reject transactions solely because their role in negotiating on behalf of the stockholders would cause them to remain as defendants until the end of any litigation challenging the transaction.”
- Plaintiffs’ suggested rule “might also provide incentives for a controlling stockholder to proceed by means of a tender offer to the minority stockholders, and thus potentially avoid the need to actively negotiate with a special committee.”
- “Establishing a rule that all directors must remain as parties in litigation involving a transaction with a controlling stockholder would thus reduce the benefits that the General Assembly anticipated in adopting Section 102(b)(7),” namely “that directors would not be willing to make decisions that would benefit stockholders if they faced personal liability for making them.”
Three key takeaways
- This decision greatly enhances the effectiveness of charter provisions modeled after 102(b)(7) of the DGCL. It is now clear that the sufficiency of the plaintiff’s loyalty or bad faith claims, to the extent they are asserted, must be addressed on a motion to dismiss. If they cannot independently survive a motion to dismiss, and the independent directors in issue are protected by 102(b)(7) charter provisions, then those directors should be dismissed from the case, notwithstanding the presence of the controlling stockholder or affiliate directors in the case.
- The court’s decision does not displace or alter the rule that “[i]nterested fiduciaries, often the proverbial deep-pocketed defendants, will continue to be required to prove that the transaction was entirely fair to the minority stockholders, because the plaintiffs’ well-pled claims against the interested parties in a controller transaction cannot be dismissed before trial, regardless of whether the independent directors remain as defendants.”
- The court noted that “if plaintiffs do not have sufficient evidence to plead non-exculpated claims against the independent directors at the pleading stage, they may bring such claims later. Because most transactions are brought immediately after − or even before − the announcement of the challenged, but still typically unconsummated, transaction, plaintiffs will usually have ample time to bring well-pled claims that the independent directors breached their duty of loyalty within the three-year statute of limitations period.”