On May 14, 2015, in a landmark ruling with important implications for the potential liabilities of independent directors of companies involved in M&A transactions, the Delaware Supreme Court held that in order to state a claim for damages against directors of a company that has an exculpatory provision in its corporate charter, a plaintiff must plead non-exculpated claims against the directors, even if the company is involved in an interested transaction subject to “entire fairness” review. The Court’s opinion highlights the importance of the independent directors’ role and also underscores the importance of exculpatory charter provisions. The Court’s opinion in In re Cornerstone Therapeutics, Inc. can be found here.
The Court’s ruling involved two different cases in which plaintiff shareholders had filed damages claims against the boards of companies where a controlling shareholder, that had board representation, was acquiring the remainder of the companies’ shares. In each case, the companies involved had formed a special committee of independent directors to review the transaction and to negotiate with the controlling shareholder. In each case, the companies’ minority shareholders had approved the transaction. Nevertheless, plaintiff shareholders filed lawsuits against the companies’ boards – including as defendants both the interested directors and the independent directors – alleging that the directors had breached their fiduciary duties by approving transactions that were unfair to the minority shareholders.
In both cases, the independent directors had moved to dismiss the claims against them. Their dismissal motions relied on the fact that each of the companies had an exculpatory clause in their corporate charters. (As discussed here, Delaware Corporations Code Section 102(b)(7) authorizes shareholders to include a clause in a corporation’s charter eliminating personal liability of a director to shareholders for monetary damages for breach of fiduciary duty, provided that such clause does not eliminate liability (1) for “any breach of the director’s duty of loyalty,” (2) “for acts or omissions not in good faith or which involve intentional misconduct or a knowing violation of law,” and (3) “for any transaction from which the director derived an improper personal benefit.”) The defendants argued that the plaintiffs had failed to plead non-exculpated allegations against them, and therefore that the claims against them should be dismissed.
The plaintiffs contended that because the share purchases represented interested transactions, the “entire fairness” standard of review applied. (As discussed here, the entire fairness standard is Delaware’s “most onerous standard,” which applies when the board “labors under actual conflict of interest.” When the standard applies, the defendants must establish that the transaction “was the product of both fair dealing and fair price.” The transaction must be “objectively fair, independent of the board’s beliefs.”) The plaintiffs argued that because interested parties were involved in the transactions, the possibility of conflict of interest justified a pleading-stage inference of disloyalty – not just as to the interested directors, but as to the independent directors as well.
In each case, the trial court judges, relying on prior Delaware Supreme Court case authority, agreed with the plaintiffs and denied the motions to dismiss. However, because they were troubled by the result (that is, that the independent directors had to remain as defendants in the case even though the plaintiffs had pled no non-exculpated misconduct against them), the trial court certified interlocutory appeals of the cases to the Delaware Supreme Court. The two cases were consolidated for purposes of the appeal.
The May 14 Decision
In a unanimous opinion written by Chief Justice Leo E. Strine, Jr., the Delaware Supreme Court reversed the lower court rulings and remanded the cases for further proceedings. The Court said that “even if a plaintiff has pled facts that, if true, would require the transaction to be subject to the entire fairness standard of review, and the interested parties to face a claim for breach of their duty of loyalty, the independent directors do not automatically have to remain defendants.” If the independent directors are “protected by an exculpatory charter provision and the plaintiffs are unable to plead a non-exculpated claim against them, those directors are entitled to have the claims against them dismissed.”
In reaching its decision, the Court examined the effect of the exculpatory provisions in the respective companies’ corporate charters. The Court said that “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.” The mere fact that the plaintiff had pled facts sufficient to support the application of the entire fairness standard does not, by itself, relieve the plaintiff of the requirement to plead a non-exculpated claim against each independent director defendant.
In support of its decision, the Court noted, among other things, that a contrary ruling would “increase costs for disinterested directors, corporations and stockholders, without providing a corresponding benefit.” A contrary ruling would also “create incentives for independent directors to avoid serving as special committee members or to reject transactions solely because of their role in negotiating on behalf of shareholders.” The “fear” that directors might face personal liability for “potentially value-maximizing business decisions” might be dissuaded from making those kinds of decisions is the reason that Section 102(b)(7) was adopted in the first place.
The Court’s opinion underscores the importance of exculpatory charter provisions. The provisions not only provide substantial liability protection for corporate directors but they provide a form of protection may be invoked at the initial pleading stage. It provides a way for directors who qualify for the provision’s protection to extricate themselves from liability lawsuits at the outset.
The Court’s opinion also highlights the importance of the independent directors’ role. The Court emphasized the ways in which disinterested directors can protect the interests of the corporation and of minority shareholders, even when the corporation is involved in a transaction with an interested party.
It is important to note that the protective effect of the Court’s ruling extends only to the independent directors. The defendants who were the interested parties to the transaction will remain in the case. If it is later established that the interested parties violated their fiduciary duties, they will held liable to the minority shareholders. But where the plaintiffs have alleged no facts to suggest that independent directors had engaged in non-exculpated misconduct, the independent directors are entitled to have the claims against them dismissed – even where the plaintiffs have pled sufficient facts to require the application of the entire fairness standard.
The fact that the independent directors can be dismissed even when the entire fairness standard applies is significant. The entire fairness standard is, as the Court itself has said, “onerous.” The requirements to meet the standard are high. But even where the high standard applies, plaintiffs must still present allegations that each director defendant individually engaged in non-exculpated misconduct in order for the claims against that defendant to survive a motion to dismiss.
Francis Pileggi’s May 16, 2015 post on his Delaware Corporate & Commercial Litigation Blog about the Supreme Court’s ruling can be found here. Frank Reynolds’ May 15, 2015 Thomson Reuters article about the ruling can be found here.
Special thanks to a loyal reader for sending me a copy of the Delaware Supreme Court opinion.
ICYMI: Delaware Senate Passes Bill Barring Fee-Shifting Bylaws: On May 12, 2015, the Delaware Senate passed Senate Bill (S.B.) 75 (here) that would amend Delaware law to prohibit Delaware stock-based companies from adopting fee-shifting bylaws. The bill also expressly allows companies to adopt forum-selection clauses that establish Delaware as the exclusive venue for any shareholder litigation.
As readers will recall, as discussed here, in May 2014, the Delaware Supreme Court in the ATP Tour, Inc. v. Deutscher Tennis Bund case had upheld the validity of a corporate bylaw provision shifting fees to an unsuccessful litigant in shareholder litigation. The ruling proved to be highly controversial (as discussed, for example, here). Early efforts last year to address the ruling in the legislature ultimately were tabled and in the interim the debate about fee-shifting by laws has continued to rage. Now that the Senate has voted to approve the legislation banning fee-shifting bylaws for Delaware stock corporations, the legislation will now move to the Delaware House for its consideration.
A May 13, 2015 memo from the Ballard, Spahr law firm discussion the Delaware Senate’s action on the bill can be found here.
D&O Liabilities in China: The potential liabilities of corporate directors and officers are of course dependent on the requirements of applicable law. That means that corporate officials’ liability exposures can vary from state to state. There are even greater variations from country to country. In a global economy, questions about the potential liability of directors and officers in non-U.S. countries arise with increasing frequency. Given China’s huge and growing role in the global economy, questions about the potential liability of directors and officers under Chinese law are increasingly frequent.
For that reason, readers may be interested in reviewing this May 8, 2015 article entitled “D&O Liability Insurance: Legal Issues under PRC Law” (here) by Jia Hui of the DeHeng Law Offices. The article provides a good overview of the basic legal duties and liability exposures of directors and officers under Chinese law. As the article points out, in light of the various accounting scandals involving Chinese companies that have arisen, these considerations are increasingly important.