Delaware Corporate Law Update

Updates on Delaware Corporate Law by Evan O. Williford, Esq., Delaware Corporate Litigation Attorney.

Close Board Ties And A Shared Airplane Eliminate Independence

Earlier this month Chief Justice Strine authored an opinion (Sandys v. Pincus) holding that close ties among certain board members, including co-owning an airplane, caused key directors to be non-independent.  Therefore, the Delaware Supreme Court reversed Chancery’s grant of a motion to dismiss derivative claims for plaintiff not having demanded that the board bring them.

Plaintiff alleged that top managers and directors of Zynga Inc. breached their fiduciary duties by selling stock while in possession of non-public information which, when it became public later, caused Zynga’s stock price to drop some 74%.  After quickly concluding three of Zynga’s nine directors were interested or non-independent, Sandys primarily concerns three additional directors:  Ellen Siminoff, William Gordon, and John Doerr.

Plaintiff alleged that Siminoff and her husband co-owned an airplane with interested director Pincus (Zynga’s Chairman, controlling stockholder, and former CEO) and that she was a “close family friend” of that director.  The Court criticized plaintiff for not getting more information about the relationship, either in a books and records lawsuit plaintiff had previously filed against Zynga or simply from a search engine such as “the tool provided by the company whose name has become a verb”.  Nevertheless, the Court held Siminoff lacked independence because joint plane ownership was “suggestive of the type of very close personal relationship that, like family ties, one would expect to heavily influence a human’s ability to exercise impartial judgment.”

Plaintiff alleged a number of facts about Gordon and Doerr including that (1) both are partners in Kleiner Perkins, a venture capital firm that controls 9.2% of Zynga’s stock; (2) Kleiner Perkins invested in a company co-founded by Pincus’ wife; and (3) Kleiner Perkins had invested in and obtained board seats at another company with another interested director.  Moreover, the board had determined Gordon and Doerr non-independent for purposes of rules promulgated by the NASDAQ stock exchange.  The Court again criticized plaintiffs for not seeking additional information including the reasons for the NASDAQ determination.  Nevertheless, it ruled Gordon and Doerr non-independent where alleged facts suggest directors belong to “networks [that] arise of repeat players who cut each other into beneficial roles in various situations” and where the board itself has determined them non-independent.  Conversely, it held that plaintiffs need not plead a “detailed calendar of social interactions”.

Justice Valihura authored a (uncommon though certainly not unheard of) dissent.  As to Gordon and Doerr, Valihura cited the lack of pled facts on the size or materiality of the ties or the relevant reasons for the NASDAQ determination.  As to Siminoff, Valihura pointed to plaintiff’s own description of the shared airplane as evidencing a “business” relationship as insufficient to result in non-independence.

Key take-aways:

  • The Court did not announce a new standard on when close business or personal ties result in non-independence. Nevertheless, Sandys could lead to Delaware courts being more willing to hold directors non-independent in close cases involving specific pleaded facts that reasonably suggest possible bias.
  • It behooves all lawyers to use search engines in light of the massive amount of information available online, including before filing complaints. The Court cautions lawyers to use them to find information of a “reliable” nature such as “articles in reputable newspapers and journals, postings on official company websites, and information on university websites”.
  • The appeal concerned a motion to dismiss ruling using a somewhat plaintiff-friendly standard. Delaware courts will be more skeptical as to whether – after trial – a plaintiff has proven a director non-independent for purposes of invoking the stringent entire fairness standard.
  • Plaintiffs seeking pre-lawsuit books and records should consider asking for information about director independence if that issue is potentially relevant.
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Filed under: Delaware Supreme Court, Demand Futility, Derivative Actions, Director Independence, Fiduciary Duties, Section 220 Books and Records

Good Things (Sometimes) Come To Those Who Wait: Two Recent Cases Show Pros And Cons To Seeking Books and Records Before Suing

When considering stockholder litigation in Chancery, one of the decisions plaintiffs face is whether to (1) sue immediately or (2) seek books and records under 8 Del. C. § 220 hoping for documents to help survive a motion to dismiss.  This summer, two cases where plaintiffs took the latter route had very different outcomes.

In August, the Court in In re Investors Bancorp, Inc. Stockholder Litigation considered cross motions to appoint lead plaintiffs in a case attacking director compensation as self-interested.  One plaintiff served a books and records request, obtained documents, and filed a complaint twice as long as the other.  While the Court complimented all counsel as “highly competent,” it placed decisive weight on the significant additional information the former uncovered.  For instance, in arguing that the compensation was a self-interested quid pro quo scheme, the latter solely used temporal proximity while the former cited board minutes.  The Court found that the information added by the former counsel was “not fluff;” rather, the former used documents “including board and compensation committee meeting minutes, to provide meaningful, additional factual support for their allegations.”

In June, however, the Court held a complaint filed after litigating a Section 220 action was precluded by the dismissal of another similar complaint two years earlier (Bensoussan).  The Court responded to plaintiff’s argument that the original plaintiff was an inadequate representative by ruling it was reluctant to judge “inadequacy based on the contents of documents obtained in response to a Section 220 demand because that approach ‘encourages hindsight review of conduct’”.  (A plaintiff in such a situation may also contend, whether or not based upon additional books and records, that the claims in the later suit are substantively different from the ones in the prior suit.)  The Court cited two other Delaware cases with similar outcomes.

Thus, as one of the “tools at hand” a books and records demand is a double-edged sword: it may lead to a superior complaint or a precluded one.  In determining whether to make such a demand plaintiffs’ counsel should carefully consider and monitor, among other things: (1) the likelihood of other similar complaints being filed; (2) the likelihood of uncovering evidence that could make the difference on a motion to dismiss (a surviving plaintiff can of course seek merits discovery); and (3) the speed with which the demand will procure helpful documents.  (As the Court in Investors Bancorp noted, a plaintiff faced with a slow demand response can always decide to abandon it and file a merits suit anyway.)

Filed under: Court of Chancery, Derivative Actions, Preclusion, Section 220 Books and Records

Court of Chancery Rejects Summary Judgment As To Loyalty Claims Against VC Investors

Today the Court of Chancery released a memorandum opinion (available here) rejecting much of defendants’ summary judgment motion in a case brought by a unitholder in a Delaware LLC against two venture capital firms and/or their affiliates that had collectively acquired control of the LLC.  By way of disclosure, this firm represents plaintiffs in the litigation.

Plaintiff is a unitholder and former CEO of Adhezion Biomedical LLC, who challenged a series of issuances of preferred units and other rights to defendants including two venture capital firms/affiliates of those firms, Originate Ventures, LLC and Liberty Advisors, Inc.  Plaintiff claimed that the issuances breached defendants’ duties of care and loyalty and obligation of good faith, and violated provisions in the LLC Agreement requiring a class vote by common unitholders.  The Court granted summary judgment as to the duty of care and obligation of good faith claims, but denied it as to plaintiffs’ claims for breach of the duty of loyalty and based upon the class vote requirement.

Noteworthy sections of the Court’s ruling included the following:

  • The Court found a genuine issue of material fact as to whether the two VC firms and their affiliates should be treated as a group for purposes of imposing controlling stockholder duties upon them.  The two VC firms and their affiliates collectively owned more than 66% of the voting units, controlled two of five directors, and had parallel economic interests, and plaintiff identified multiple communications supporting an inference that they exerted actual control of capital raising activities.
  • The Court rejected defendants’ argument that director approval immunized the transactions based upon a provision in the LLC Agreement similar, but not identical, to Section 144 of the Delaware General Corporation Law.  In addition to noting other material factual disputes, the Court ruled that, as a matter of law, in any event it would not operate as a safe harbor against review of the challenged transactions for breach of the duty of loyalty under the entire fairness standard of review.

Filed under: Controlling Stockholder, Court of Chancery, Derivative Actions, Fiduciary Duties

Chancery Zaps Controlling Stockholder For $1.2B In Damages

On Friday, now-Chancellor Leo E. Strine Jr. issued a lengthy post-trial opinion, In re Southern Peru Copper Corp. Shareholder Derivative Litigation, available here, in which he required a controlling stockholder to return $1.2B in stock in connection with a transaction between it and a corporation it controlled.  The case has a number of details of interest to those who advise as to or litigate such transactions or otherwise have an interest on Delaware corporate law.

Controlling stockholder Grupo Mexico ultimately owned about 54% of the stock of Southern Peru Copper Corp. stock and almost all of Minera Mexico’s.  Each of Cerro Trading Company, Inc. (owned in turn by the Pritzker family) and Phelps Dodge Corporation owned about 14% of Southern Peru, although such shares were unregistered and could not easily be sold under federal securities laws.

Grupo Mexico proposed to Southern Peru’s board of directors that the latter buy the former’s shares in Minera Mexico in exchange for approximately $3 billion in Southern Peru stock.  While Southern Peru’s stock was publicly traded, allowing a ready calculation of its value, Minera Mexico’s was not.

Southern Peru formed a special committee of four directors to evaluate the proposal.  The Special Committee hired Latham & Watkins as legal, and Goldman Sachs as financial, advisor (among others).  The Special Committee did not lack for credentials and included a Columbia Law grad who had worked at Wachtell Lipton, a Ph.D. in finance from the Wharton School, and another individual with both an MBA and a JD who had managed multi-billion dollar companies.  The most active member, Harold Handelsman, was an attorney for the Pritzker family.

After several months of due diligence Goldman Sachs concluded in an “Illustrative Give/Get Analysis” presented to the Special Committee that Southern Peru was being asked to “give” stock with a market price of $3.1B to “get” an asset worth no more than $1.7B.  The Special Committee was not specifically given the mandate to negotiate the deal but did so anyway.  It made a counterproposal (not reported in the proxy statement) to issue about $2B of Southern Peru stock.  Grupo Mexico eventually proposed to acquire $2.76B in shares.  Ultimately Goldman Sachs issued a fairness analysis and opinion and the Special Committee agreed to recommend the revised proposal to the board.

The Court criticized the Special Committee for operating “in the confined mindset of directors of a controlled company” and not proposing other alternative transactions to Grupo.  The Court acknowledged that Grupo Mexico could always veto such transactions but suggested that it would have been a positive factor in the legal analysis.

According to the Court, after Grupo Mexico stood pat on its demands, the Special Committee and Goldman Sachs adopted a number of arguments to get to the desired result that the transaction was fair, each of which the Court rejected (including an early argument, later abandoned, that Southern Peru’s stock price did not represent that stock’s real value).

In side-deals, Southern Peru stockholders Cerro and Phelps Dodge, who wanted to monetize their holdings, agreed to support the deal if Southern Peru would register their shares.  While the Special Committee chose not to take part in the negotiations on this, Handelsman was very much involved.  Handelsman was also heavily involved with the Special Committee but decided not to participate in its final vote on the advice of Goldman Sachs’ counsel.

Because the deal was conditioned on a two-thirds vote of all stockholders, not a majority-of-the-minority vote, Grupo Mexico only needed the additional vote of either Cerra or Phelps Dodge.  While the Cerro agreement was conditioned on the approval of the underlying deal by the Special Committee the Phelps Dodge agreement was not, leaving the Special Committee without veto power.

By the time of the stockholder vote five months later Southern Peru had significantly exceeded the projections upon which Goldman’s fairness opinion had been based and its stock price had risen substantially.  The Court criticized the Special Committee for not seeking to renegotiate the deal or ask Goldman to update its analysis.

In a post-trial opinion the Court held that entire fairness was the appropriate standard of review and the transaction was not entirely fair to Southern Peru.  The Court then awarded damages in the amount of Southern Peru stock in excess of that which Grupo Mexico should have received.  The Court refused to award rescissory damages (which would have been larger given Southern Peru’s subsequent performance) because of plaintiff’s six-year delay in proceeding to trial.

Notable points other than those already mentioned:

  • Once again the opinion demonstrates the skill with which Chancery judicial personnel will evaluate economic arguments on valuation.
  • The Court held that, with respect to a controlling stockholder transaction, even a special committee with independent and disinterested members must show that it functioned well and the Court will examine its conclusion substantively.
  • The Court held a disclosure materially incomplete for not reporting the Special Committee’s counteroffer, which was materially higher than the eventual price and made after due diligence and a presentation by the financial advisor.
  • Even a lengthy special committee negotiating process, including well-credentialed members and financial and legal advisors, will not immunize a large controlling stockholder deal if it fundamentally does not make economic sense.
  • Interestingly, the Court noted derivative plaintiff’s failure to attend trial, although it rejected a motion to disqualify him as inadequate.
  • The Court noted its earlier dismissal of the Special Committee members themselves including Handelsman and reaffirmed its holding that neither bad faith nor self-dealing had been shown.  Nevertheless, it held that the interest of Handelsman in obtaining liquidity for Cerro had compromised his effectiveness on behalf of the Special Committee.
  • The Court criticized current Delaware law allowing an effective special committee process as to a controlling stockholder transaction to shift the burden of proof at most (as opposed to restoring business judgment rule).  The Court noted that while measures such as special committees are seen as beneficial to Delaware corporations and to be encouraged, burden shifting may not be much of an encouragement as it is almost never outcome-determinative because the Court is rarely in equipoise.
  • The Court again proposed that a combination of sufficient protective procedural devices (use of a special committee with negotiation, approval, and veto authority; and a fully informed majority-of-the-minority vote by stockholders) cause the business judgment rule to be restored.  But the Court also suggested that the Delaware Supreme Court would have to modify its precedent (e.g. the venerable Kahn v. Lynch) to do so.

Filed under: Controlling Stockholder, Court of Chancery, Derivative Actions, Fiduciary Duties

Chancery Dismisses Derivative Case Against Goldman

Today the Court issued a decision in derivative litigation regarding Goldman Sachs and its trading strategies and compensation leading up to mortgage and housing crisis of a few years ago.  Vice Chancellor Glasscock, recently appointed to the bench, issued the decision granting defendants’ motion to dismiss.

The decision reaffirms, from the newest member of the Court, the old principle that the Court of Chancery will not accept breach of fiduciary duty suits bottomed on questions of whether a particular business or compensation strategy was wise.

It also reaffirms the principle that donations by a company to a director’s charities do not in and of themselves prevent that director from being independent.

Filed under: Court of Chancery, Derivative Actions, Fiduciary Duties

Chancery Bars Derivative Actions By Creditors Of LLCs and LPs

For several years it has been established that creditors of Delaware corporations have standing to bring derivative actions when the debtor corporation is insolvent.  A recent Court of Chancery opinion, however,  CML V, LLC v. Bax, C.A. No. 5373-VLC (Del. Ch. Nov. 3, 2010), has held that that is not the case with respect to Delaware  limited liability companies (LLCs) – and implicitly Delaware limited partnerships (LPs).

In 2007, the Delaware Supreme Court had held that creditors had standing to bring derivative actions in the name of debtor insolvent Delaware corporations.   N. Am. Catholic Educ. Prog. Found., Inc. v. Gheewalla, 930 A.2d 92, 101 (Del. 2007) (“Gheewalla”).  Late last year, the Court of Chancery held in Bax that creditors of Delaware LLCs cannot bring such derivative actions.  The Court did so based on a provision of the Delaware LLC Act requiring contemporaneous ownership of membership interests.  6 Del. C. § 18-1002.  Section 18-1002, unlike the equivalent corporation law provision,  states that plaintiff “must” be a “member or an assignee” of the LLC “at the time of the transaction of which the plaintiff complains” (known as the contemporaneous ownership requirement).  The Delaware LP Act contains substantively identical language.  While the Delaware General Corporation Law also contains a contemporaneous ownership provision, it is not worded to expressly require a derivative plaintiff to be a stockholder.  See 8 Del. C. § 327 (“In any derivative suit instituted by a stockholder of a corporation, it shall be averred in the complaint that the plaintiff was a stockholder of the corporation at the time of the transaction . . . .).

The Court was apparently not entirely comfortable with either of the two conflicting rules of Delaware law from which the holding in Bax resulted.  Vice Chancellor J. Travis Laster noted his prior criticism of the contemporaneous ownership requirement.  In justifying its decision, the Court noted the methods LLC creditors have to protect themselves, such as requiring protection in an LLC agreement.  The Court also referenced the criticism of creditor derivative standing itself by another member of the Court, though acknowledging that such standing is now the law under Gheewalla at least with respect to insolvent Delaware corporations.

Filed under: Court of Chancery, Derivative Actions, Derivative Standing

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Disclaimer

Delaware Corporate Law Update solely reflect the views of Evan Williford of The Williford Firm, LLP. Its purpose is to provide general information concerning Delaware law; no representation is made about the accuracy of any information contained herein, and it may or may not be updated to reflect subsequent relevant events. This website is not intended to provide legal advice. It does not form any attorney-client relationship and it is not a substitute for one.