Joseph M. McLaughlin, partner at Simpson Thacher & Bartlett, writes that three recent Delaware Court of Chancery decisions offer guidance on the scope of director misconduct that can be exculpated and what plaintiffs must plead to demonstrate that defendant directors consciously and intentionally disregarded their fiduciary duty of care, thereby establishing non-exculpated bad faith.
By Joseph M. McLaughlin|December 11, 2008 at 12:00 AM
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The exculpatory effect of a corporate charter provision under §102(b)(7) of the Delaware General Corporation Law is to free directors of personal liability in damages for breaches of the fiduciary duty of care, but not duty of loyalty violations, bad faith claims and certain other conduct. Where the directors are shielded from liability for damages by an exculpatory charter provision, absent particularized allegations of director bad faith or other non-exculpable conduct, courts applying Delaware law have dismissed at the pleading stage claims based on breach of the duty of care, including claims alleging disclosure violations and waste. The factual basis for alleged liability is determinative of whether the alleged breach can be exculpated. Post-Disney, Delaware law is clear that gross negligence by a director can be exculpated, but bad faith, intentional dereliction of duty, a conscious disregard for one’s responsibilities, is non-exculpable. Three recent Delaware Court of Chancery decisions offer guidance on the scope of director misconduct that can be exculpated and what plaintiffs must plead to demonstrate that defendant directors consciously and intentionally disregarded their fiduciary duty of care, thereby establishing non-exculpated bad faith. Overview of Exculpatory Provisions The primary purpose of an exculpatory provision is to encourage directors to adopt potentially value-maximizing business strategies without concern for personal liability, as long as they act in good faith. A charter exculpatory provision operates to insulate directors from liability for damage claims by stockholders and the corporation arising out of breaches of the duty of care. Although §102(b)(7) does not mention creditors specifically, courts have interpreted the exculpation to extend to all claims for damages belonging to the corporation, regardless of whether those claims are asserted derivatively by stockholders or by creditors when the corporation is insolvent.1 The statutory basis for a charter exculpatory provision is §102(b)(7) of the DGCL, which itself is based on section 2.02(b)(4) of the Model Business Corporation Act. Section 102(b)(7) was enacted in response to Smith v. Van Gorkom,2 in which the directors of a corporation were held personally liable to stockholders for a breach of the fiduciary duty of due care in agreeing to a merger proposal. Concern that qualified individuals would be reluctant to serve as corporate directors under the Van Gorkom standard roused the Delaware General Assembly in 1986 to give stockholders the ability to contract with the corporation and its directors, in the certificate of incorporation, regarding the directors’ liability to the corporation or the stockholders. Most corporations in Delaware (and elsewhere) now include an article in their certificate that essentially tracks the language of DGCL §102(b)(7), which authorizes a provision in the certificate of incorporation eliminating or limiting the liability of directors to the corporation or its stockholders for money damages for breach of fiduciary duty as a director, unless based on: (i) the duty of loyalty (ii) acts or omissions not in good faith or which involve intentional misconduct or a knowing violation of law; (iii) §174 of the Delaware General Corporation Law (regarding payment of unlawful dividends, stock purchases or redemptions), or (iv) a transaction from which the director derived an improper personal benefit. Broadly speaking, review of a board’s process in making a decision implicates the duty of care under a gross negligence standard, while potential issues of director independence and self-interest implicate the duty of loyalty. Stated differently, a charter can exculpate directors for conduct amounting to gross negligence (including directors’ failure to inform themselves of reasonably available material facts), but not for conduct constituting a breach of the duty of loyalty. That is, although the statute separately enumerates loyalty, good faith and improper personal benefit, conduct falling under any of the exceptions to §102(b)(7) usually qualifies as a breach of the duty of loyalty. The definition of gross negligence used in Delaware corporate law is itself extremely stringent, meaning either reckless indifference to or deliberate disregard of all stockholders, or actions outside the generous bounds of reason.3 Because duty of care violations are actionable only if a director acts or fails to act with gross negligence, and because exculpatory provisions ordinarily bar money damages arising from a duty of care violation, duty of care violations are rarely found. Delaware decisions also extend the protections of §102(b)(7) to claims not denominated as breach of the duty of care, such as waste and disclosure-based claims. For example, unless a complaint alleges with particularity that disclosure violations were made in bad faith, disclosure claims are dismissed once the directors invoke the corporation’s exculpatory provision.4 The exculpatory shield is in the nature of an affirmative defense. The Delaware Supreme Court has expressed a preference for trial courts to address a dismissal motion that invokes an exculpatory provision as a motion for summary judgment, but has deemed it harmless error not to do so.5 The trial court can take judicial notice of a Certificate of Incorporation that was filed with the Delaware Secretary of State. Accordingly, if a court determines on a motion to dismiss that the complaint does not allege well-pleaded, particularized facts showing conduct that would fit within one of the exceptions to an exculpatory provision, dismissal is appropriate. Defendants seeking exculpation under such a provision will bear the burden of establishing each of its elements. To survive a motion to dismiss, the complaint must allege particularized facts demonstrating that the directors’ conduct falls within an exception to §102(b)(7), and therefore states a valid, non-exculpated claim. In practice, this means that in actions against directors of a Delaware corporation with a §102(b)(7) charter provision, the focus of the case narrows to whether the complaint alleges facts which, if true, support a conclusion that the directors breached their duty of loyalty or otherwise engaged in conduct not immunized by the exculpatory charter provision.6 Claims of “bad faith” and breach of the duty of loyalty are the most frequently alleged categories of conduct that cannot be exculpated. Recent Delaware law has taken pains to establish a line between gross negligence, which is exculpated, and bad faith conduct or omissions, which is not. Delaware law requires proof of an improper motive or conscious, bad faith state of mind to establish that conduct was carried out not in good faith. In In re Walt Disney Co. Deriv. Litig.,7 the leading Delaware case enunciating the standard of what constitutes a failure to act in “good faith,” the Delaware Supreme Court stated that, “To adopt a definition of bad faith that would cause a violation of the duty of care automatically to become an act or omission ‘not in good faith,’ would eviscerate the protections accorded to directors by the General Assembly’s adoption of §102(b)(7).” In Disney, the Supreme Court then ruled that bad faith can be demonstrated through a showing of “subjective bad faith” – i.e., “fiduciary conduct motivated by an actual intent to do harm” – as well as “intentional dereliction of duty, a conscious disregard for one’s responsibilities.” The Supreme Court outlined the three “most salient” examples of conduct that would constitute a failure to act in good faith and thus cannot be exculpated: where the fiduciary (i) intentionally acts with a purpose other than that of advancing the best interests of the corporation; (ii) acts with the intent to violate applicable law, or (iii) intentionally fails to act in the face of a known duty to act, demonstrating a conscious disregard for his duties. This analytical framework, which equates good faith with the duty of loyalty, is consistent with the Delaware precept that “[by] definition, a director cannot simultaneously act in bad faith and loyally towards the corporation and its stockholders.”8 It is important to italicize what an exculpation provision does not do. It does not protect officers, employees or other non-director agents. It does not eliminate directors’ fiduciary duty of care in their decision-making process and oversight responsibilities; a court may still grant injunctive relief for violations of that duty.9 If judicial review of a transaction requires the entire fairness standard, an exculpatory provision cannot eliminate an entire fairness analysis, but the court can determine that the directors are exculpated from monetary damages after the basis for their potential liability has been decided under that standard.10Recent Case Law Three decisions this year are instructive in distinguishing exculpated and non-exculpated conduct. Two key lessons are drawn from McPadden v. Sidhu11: (i) non-director officers receive no protection from an exculpatory provision, and (ii) a non-purposeful absence of care, no matter how serious, does not by itself constitute bad faith and therefore can be exculpated. Plaintiff in McPadden sought to bring derivative breach of fiduciary duty claims against the board of i2 Technologies, arising out of its approval of the sale of a wholly-owned subsidiary – allegedly at a deep discount to true value – to a management team led by a corporate vice president, against whom unjust enrichment was alleged. Plaintiff alleged that pre-suit demand was excused under the second prong of the Aronson test, i.e., even if the board was disinterested and independent, demand was excused as futile if plaintiff pled particularized facts raising reasonable doubt that the relevant transaction was the product of a valid exercise of business judgment. Chancellor William B. Chandler, III agreed that the duty of care violation alleged was sufficient to create reasonable doubt that the sale approval for the subsidiary was the product of a valid exercise of business judgment. The board faltered at the outset by authorizing the corporate officer interested in purchasing the subsidiary to run the sale process, knowing of the officer’s interest in leading a possible management purchase of the subsidiary. With the officer running the process, no broker or investment banker was hired to assist in the process. The complaint alleged that despite having tasked a potential purchaser with running the sale process, the board engaged in minimal oversight of the process. In a process which yielded three offers, the officer never contacted the most obvious potential buyers, and the officer’s management group emerged as the highest bidder at $3 million. Four days before the board met to discuss the offers, the company’s regular investment banker distributed two sets of financial projections regarding the subsidiary. The board knew the projections were provided by the officer interested in purchasing the subsidiary. The board also knew the banker’s preliminary valuation was based solely on these “buyer” projections, but it nevertheless accepted the $3 million offer, which was at the lowest end of the valuation range of $3 to $7 million. Two years later the buyer resold the subsidiary for nearly ten times that amount. The court concluded that the board’s conduct constituted gross negligence. But what is the effect of an exculpatory provision in such circumstances? First, though an officer owes to the corporation identical fiduciary duties of care and loyalty, an officer does not receive any protection from an exculpatory provision, so the officer’s motion to dismiss was denied. As to the directors, the court observed that bad faith cannot be exculpated, but gross negligence can. “Delaware’s current understanding of gross negligence is conduct that constitutes reckless indifference or actions that are without the bounds of reason.” The i2 board, the court determined, was not alleged to have acted in bad faith, i.e., with subjective bad intent or a conscious disregard of its responsibilities. Accordingly, the court dismissed the breach of fiduciary duty claim against the directors. Similarly, In Re Lear Corp. Sh. Litig.,12 plaintiff sought to bring derivative breach of fiduciary duty claims against the board of Lear, based on the Lear board’s agreement to pay the bidder under a merger agreement a No-Vote Termination Fee of $25 million in exchange for a $100 million increase in the merger consideration, which was negotiated by the Lear board to help secure the Lear stockholders’ approval of the merger. After a thorough shopping of the company financial and strategic buyers, the Lear board approved a going-private transaction pursuant to a merger agreement with American Real Estate Partners (“AREP”), Lear’s largest stockholder. The original merger agreement gave AREP the right to buy Lear for $36 per share, subject to Lear stockholder approval of the merger agreement. No topping bid emerged during a 45-day “go shop” period. Following preliminary injunction litigation of a Revlon claim (failure to maximize shareholder value in connection with a merger that will result in a change of control), Lear encountered resistance in securing votes for the merger, and engaged in extensive negotiations with AREP, which culminated in AREP agreeing to pay $1.25 cents more per share. In exchange, the Lear board agreed to pay AREP a No-Vote Termination Fee of $25 million if the Lear stockholders rejected revised merger agreement. The stockholders did not approve the merger, and plaintiffs then amended their complaint to allege that the Lear board breached its fiduciary duties by granting AREP the No-Vote Termination Fee in exchange for the $1.25 per stock increase in its offer. The Lear directors acted in bad faith, plaintiffs alleged, not because they were interested or lacked independence, but because they supposedly agreed to the No-Vote Termination Fee knowing that the $1.25 per stock price increase would likely not be sufficient to attract a majority vote in favor of the merger. To avoid Lear’s exculpation clause, Vice Chancellor Leo E. Strine, Jr., ruled, plaintiffs needed to plead facts supporting an inference that the Lear board, “despite having no financial motive to injure Lear or its stockholders, acted in bad faith . . . . Such a claim cannot rest on facts that simply support the notion that the directors made an unreasonable or even grossly unreasonable judgment. Rather, it must rest on facts that support a fair inference that the directors consciously acted in a manner contrary to the interests of Lear and its stockholders.” The court emphasized that to hold a disinterested director liable for a breach of the duty of loyalty for acting in bad faith, “a strong showing of misconduct must be made.” The Disney-enumerated examples of bad faith conduct, the court noted “all depended on purposeful wrongdoing, such as intentionally acting ‘with a purpose other than that of advancing the best interests of the corporation,’ acting ‘with the intent to violate applicable . . . law,’ or ‘intentionally fail[ing] to act in the face of a known duty to act.’” Dismissing fiduciary duty and waste claims, the court held that directors may take good faith actions “that they believe will benefit stockholders, even if they realize that the stockholders do not agree with them.” In the merger context, the court stated, directors may adopt a merger agreement and seek stockholder approval “if they believe that the stockholders will benefit upon adoption, even if they recognize that securing approval will be a formidable challenge.” In noteworthy dicta, the court addressed the intersection of Revlon claims and exculpatory clauses, stating that when, “as has become more common, a Revlon case simply involves the question of whether a board took enough time to market test a third-party, premium-generating deal, and there is no allegation of a self-interested bias against other bidders, a plaintiff seeking damages after the deal has closed cannot, in the presence of a §102(b)(7) clause, rest on quibbles about due care.” That is, even if a board unintentionally fails, because of gross negligence and not of bad faith or self-interest, to follow up on a superior bid and an exculpatory charter provision is in place, the plaintiff cannot recover damages, even if the board was in Revlon-mode. Which leads to a well-publicized recent decision not cited by Vice Chancellor Strine, but which may have underlay the Revlon dicta. In Ryan v. Lyondell Chemical Co.,13 Vice Chancellor John W. Noble declined to authorize an interlocutory appeal from a denial of summary judgment, in which he declined to dismiss, based on Lyondell’s exculpatory charter provision, duty of care claims against unconflicted and independent directors arising from the stockholder-approved sale of the company in July 2007 to Basell AF for $13 billion, representing a 45 percent premium over the closing share price on the last trading day before the public became aware of the potential deal. The decision is open to the objection that it expanded the concept of “bad faith” under Delaware law in the Revlon sale context because the record does not appear to support an inference that the directors intentionally breached their Revlon duties or consciously disregarded their fiduciary obligations. Despite finding that the independent and disinterested Lyondell directors actively negotiated the merger at arm’s-length with Basell, generally were informed about the value of the company, and secured a merger price that was “undeniably” fair, the court determined that the record did not clearly demonstrate the absence of issues of material fact with respect to the board’s good faith discharge of its Revlon duties in connection with the sale. Consequently, the court ruled it was premature to determine the legal effect of Lyondell’s exculpatory charter provision. The court repeatedly emphasized the preliminary nature of its summary judgment denial, referencing “simple and as yet unexplained facts” from which it was “possible to draw the reasonable inference, at least for purposes of denying summary judgment on the current record, that the directors may have consciously disregarded their known fiduciary obligations in a sale scenario.” The court underscored what it deemed “unexplained director inaction” resulting in “no apparent effort to arm themselves with specific knowledge about the present value of the company.” In particular, the court stated that on the incomplete record it was not clear that the challenged conduct, a single-bidder sale strategy, amounted only to a simple violation of the duty of care, i.e., gross negligence, because “it appeared that” (1) the directors knew, based on the filing of a Schedule 13D in May 2007, that Lyondell was “in play”; (2) the directors nevertheless did little in the ensuing two months “to prepare or to develop a strategy-consistent with” its Revlon duties; (3) the directors did little before signing a merger agreement to confirm that a better deal could not be obtained; (4) the directors did not vigorously negotiate Basell’s offer; and (5) the directors did little post-signing to confirm that a superior deal was not available. The court insisted that it “did not conflate good faith into a theory that would result in legal liability for a breach of only the directors’ duty of care.” However, its view of “the totality of the directors’ conduct” on an incomplete record prompted “the Court to question whether they may have disregarded a known duty to act and may not have faithfully engaged themselves in the sale process in a manner consistent with . . . Revlon. Whether that apparent failure to act ultimately rises to the level of something ‘more’ that constitutes ‘bad faith’ sufficient to deprive the directors of the protection of Lyondell’s exculpatory charter provision remains to be seen.” Rather than read the decision to dilute the “conscious” wrongdoing standard for determining bad faith, Ryan should be interpreted in the manner the court carefully limited its holding under the circumstances before it: a limited factual record suggesting a passive board process in the face of a well-known duty to act raised a question of material fact regarding the directors’ entitlement to exculpation. Joseph M. McLaughlin is a partner at Simpson Thacher & Bartlett.Endnotes:
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