The Delaware Court of Chancery recently denied summary judgment to directors who approved a merger transaction in just seven days, and without conducting an active pre-signing or post-signing market check, even though the only bidder offered a “blowout” price. Moreover, given the board’s failure to take an active role in negotiating the merger and in informing itself of the value of the company, the court held that the directors could not benefit from the exculpatory provision in the company’s charter at the summary judgment stage because they may have breached their duty of loyalty by acting in bad faith.
In Ryan v. Lyondell Chemical Company, et al.,1 Lyondell Chemical Company (Lyondell) was a financially strong company in a specialized manufacturing industry that was not looking to raise capital and was not otherwise for sale. Through Lyondell’s CEO, it received an unsolicited offer from Basell AF (Basell), a strategic partner, whose affiliate had recently filed a Schedule 13D after acquiring a large (but non controlling) block of Lyondell stock.2 Lyondell’s board met to consider the 13D, but it decided that an immediate response was not required. The board also made no attempt to value the company in light of the 13D filing. Aside from one brief approach by another suitor, the 13D filing did not lead to any expressions of interest in Lyondell. Two months after the 13D filing, Lyondell’s CEO met with the chairman of Basell’s parent company. Basell initially offered $40 per share, and after some negotiations during the meeting, Basell made its best offer of $48 per share in cash; this was a 45 percent premium over the stock price on the day before the 13D filing. The offer was contingent upon the signing of a merger agreement in just seven days and a break-up fee of $400 million. Over the following two days, Lyondell’s board considered the offer and formally authorized Lyondell’s CEO to negotiate with Basell.
Events then moved rather quickly. During the next several days, Lyondell retained Deutsche Bank as its financial advisor and to provide a fairness opinion, Basell conducted due diligence and the terms of the merger agreement were negotiated. At one point during these negotiations, the Lyondell board, through its CEO, asked Basell to increase its price, to reduce the break-up fee, and to include a go-shop provision. Basell emphatically refused, agreeing only to marginally reduce the break-up fee to $385 million. The following day, Deutsche Bank provided the board with its opinion that the $48 per share offer was fair. Deutsche Bank identified 20 potential suitors, but none were contacted for reasons the court did not describe. The board then voted unanimously to approve and recommend the merger to Lyondell’s stockholders – seven days after Basell’s first offer. The driving force behind the board’s decision was its belief that the substantial premium over the market price was too good not to accept, which was a 20 percent premium on the day before the merger was publicly announced. In fact, one Lyondell director testified in a deposition that he was worried “the shareholders would fire us if we didn’t take it.” Lyondell’s stockholders approved the merger almost unanimously, and it closed shortly thereafter.
Within days after the merger was announced, the first shareholder class action was filed in Texas. After the Texas court refused to preliminarily enjoin the merger vote, Plaintiff Walter Ryan (Ryan) filed in the Delaware Chancery Court. Ryan alleged, among other things, that the Lyondell board breached its fiduciary obligations articulated in Revlon, Inc. v. MacAndrews & Forbes Holdings, Inc.3 (Revlon) once the board decided to sell the company. The Lyondell board moved for summary judgment. The court initially noted that Lyondell’s charter contained an exculpatory provision adopted in accordance with 8 Del. C § 102(b)(7), which prohibited money damages against directors except for breaches of loyalty or for acts not in good faith. Thus, the board could only be held liable if the sales process it conducted was so deficient as to constitute a breach of the good faith component of the duty of loyalty.
Although the court noted that there is “no single blueprint” for fulfilling a board’s Revlon duties to seek the best transaction available in a sale, in most instances the board is required to “engage actively in the sale process.” Implicit in fulfilling these duties is that a board had sufficient knowledge of the relevant markets and the value of the company to form a reasonable belief that it acted in the best interest of the shareholders. This is where the court appeared to find the most fault with the Lyondell board, particularly given the speed of the transaction. This underlying theme in the court’s opinion is best illustrated by the court’s comment that the six or seven hours the board considered the transaction “do not inspire confidence that the board carefully considered all of the alternatives available to Lyondell.”
The court criticized the board for not conducting an active market check of any kind and for failing to successfully negotiate a go-shop provision. Even though the board argued that no other bidders emerged after the 13D filing, which effectively put a “For Sale” sign on Lyondell, the court, nevertheless, questioned why the board did not take “some action in anticipation of a possible proposal from Basell or another suitor,” such as seeking valuations from an investment banker or from management before Basell made its offer. The court recognized that no indications of interest or topping bids were received during the four months after the announcement of the merger and the shareholder vote, but it was not persuaded by the board’s position that such an implicit post-signing market check validated that it had received the best offer. What appears to have troubled the court was that it did not perceive the board to have shown that it possessed “a body of reliable evidence with which to evaluate the fairness of the transaction,” which could supplant an active sales process.4
The court disapproved of the board’s avoidance of an active role in the merger negotiations, which primarily were conducted by Lyondell’s CEO. Not only did the CEO initiate and conduct the negotiations, but also the board did not seriously push back against Basell with respect to the offer price or deal protections. Although the court found that the deal protections may have been “typical,” the court indicated that, under the circumstances, the primary problem was the board’s decision to tie its hands with a no-shop, even with a fiduciary out provision. Because the court did not find evidence that Basell would walk away without the deal protections, the court was “not persuaded that a difficult and demanding buyer justifies a board’s acquiescing in merger provisions that may undermine (to some extent) the interest of the stockholders . . . .”
The portion of the court’s opinion that likely will generate the most commentary is its finding that a question of fact exists with regard to the application of the exculpation provision in Lyondell’s charter. As with many public companies, Lyondell’s exculpation provision eliminates personal liability of its directors for breaches of the duty of care but not for breaches of the duty of loyalty. In citing Stone v. Ritter,5 the court noted that the duty of loyalty is not limited to situations where a director acts disloyally through some financial interest or other conflict of interest, but also encompasses cases in which a director does not act in good faith. In the court’s view, the Lyondell board’s conduct could rise to the level of constituting bad faith. The court distinguished a situation in which a board “simply botched the sales process” in a negligent manner with the Lyondell board which, the court stated, “appears never to have engaged fully in the process to begin with.” Because the record at the summary judgment stage did not “clearly show the Board’s good faith discharge of its Revlon duties,” the court held that a question of fact exists as to whether the procedural shortcomings of the Lyondell merger process amounts to bad faith.
We think that Ryan could be an early signal that courts will be more skeptical of passive post-signing market checks in the Revlon context, and look for boards to be more proactive in obtaining information to evaluate the value of the company than some prior decisions might suggest. Additionally, the Chancery Court’s adaptation of the good faith component of the duty of loyalty, which arose from cases involving failures to respond to express “red flags” (i.e., Caremark; Stone v. Ritter), to the mergers and acquisition context, raises serious questions about whether an exculpation provision provides an effective defense at the pre-trial stage in mergers and acquisition cases. We think that plaintiffs may increasingly try to use Ryan when a board’s sales process is being challenged in order to create obstacles for directors to prevail at the motion to dismiss and motion for summary judgment stages using an exculpation defense. Such a result appears inapposite to the policies underlying exculpation clauses and the teachings of Smith v. Van Gorkom6 and its progeny.