News

Section 220 Action is not a Substitute for Litigation Discovery.

In Central Laborers Pension Fund v. News Corp., C.A. No. 6287-VCN (Del. Ch. Nov. 30, 2011), the Delaware Court of Chancery dismissed an action to inspect the books and records of defendant News Corporation (“News”), under Section 220 of the Delaware General Corporation Law (“Section 220”), on the basis that plaintiff’s purpose for making such a demand was not proper where plaintiff had already filed a derivative complaint against News.  The derivative complaint alleged that News’s directors had breached their fiduciary duties in connection with a proposed acquisition of Shine Group Limited by News (the “Potential Transaction”).  The 220 action sought books and records for the purpose of investigating potential breaches of fiduciary duty by the News board in connection with the Proposed Transaction.  The Court found that, by filing its derivative complaint, plaintiff acknowledged—if for no other reason than to satisfy its lawyers’ ethical obligations—that it had sufficient information to support its substantive allegations in the complaint.  Thus, plaintiff’s pleadings were inconsistent, and the Court ruled that Section 220 could not be used as a substitute for litigation discovery.

Chancery Court Addresses the Meaning of a Contractual Bad Faith Claim.

In Clean Harbors, Inc. v. Safety-Kleen, Inc., C.A. No. 6177-VCP (Del. Ch. Dec. 9, 2011), the Delaware Court of Chancery declined to dismiss plaintiff’s claim that defendant Safety-Kleen, Inc. (“Safety-Kleen”) breached a contractual obligation to make a good faith determination of the fair market value of its stock in connection with the exercise of a call right set forth in an option agreement. Plaintiff Clean Harbors, Inc. (“Clean Harbors”), a competitor of Safety-Kleen, acquired shares of Safety-Kleen subject to the call right from former Safety-Kleen employees, who held Safety-Kleen options, but did not have the funds to exercise the options before they expired. Clean Harbors financed the former employees’ exercise of the options and then bought the stock from the employees for $7.50 each, a small premium.  However, only several hours after Clean Harbors closed its transaction with Safety-Kleen’s former employees, Safety-Kleen notified Clean Harbor that it was exercising a call right, under the option agreement, to purchase Clean Harbor’s shares at “fair market value,” which Safety-Kleen determined was $7.50—the same price Clean Harbors paid Safety Kleen’s former employees for their stock.  Clean Harbors alleged that Safety-Kleen breached a contractual obligation to pay it the “fair market price” of the stock and an explicit obligation, under the option agreement, to make such determination in “good faith.”  Specifically, Clean Harbors argued that $7.50 was a submarket price that Safety-Kleen’s former employees accepted only because they had no other means of salvaging some of the value of their options. Clean Harbors also argued that the $7.50 price reflected a discount for the stock being subject to a call right. The Court found that Clean Harbor’s allegations were sufficient to support a finding that the fair market value of the stock at issue was substantially higher than $7.50, and (2) Safety-Kleen had acted in “bad faith” in setting the call price. While Safety-Kleen argued that a contractual “bad faith” claim required Clean Harbors to establish that Safety-Kleen’s conduct constituted subjective bad faith–i.e., that its conduct was motivated by an actual intent to cause harm, the Court disagreed.  Specifically, the Court found that the complaint need only allege facts related to the alleged act taken in bad faith and a plausible motivation for it. Because Clean Harbors plausibly alleged that Safety-Kleen was motivated by a desire to deprive a competitor from the benefits of its bargain (which also likely satisfied the “subjective” bad faith standard), the Court declined to dismiss its complaint.

Supreme Court Upholds Application of Spanish Law to a Triple Derivative Action.

In Sagarra Inversiones, S. L., v. Cementos Portland Valderrivas, S.A., C.A. No. 6179, J. Jacobs (Del. Dec. 28, 2011), the Delaware Supreme Court affirmed a Chancery Court decision holding that plaintiff, a stockholder of Cementos Portland Valderrivas, a Spanish Corporation (“CPV”), could not assert a derivative action on behalf of a third-tier, Delaware subsidiary of CPV where plaintiff lacked standing, under Spanish law, to bring such an action.  Under Delaware law, a stockholder of a parent corporation may sue derivatively to enforce the claim of a wholly owned corporate subsidiary where the subsidiary and its parent wrongfully refuse to enforce the subsidiary’s claim directly.  Spanish law does not permit so called “double” or “triple” derivative actions—in other words, a stockholder may only pursue a derivative action at the parent level.  Plaintiff failed to make a demand on the board of the Spanish parent corporation as required, under Spanish law; thus, the Chancery Court dismissed plaintiff’s complaint.  Plaintiff advanced three arguments in favor of the application of Delaware law to the action.  First, plaintiff argued that Delaware law should be applied because it was suing to enforce a right possessed by a Delaware corporation, not a Spanish corporation.  The Court rejected this argument on the basis that plaintiff’s standing to sue derivatively on behalf of a subsidiary must derive from its ownership of shares at the parent level because the parent corporation was the only corporation in which plaintiff owned stock. Second, plaintiff argued that standing was not a principle to which Delaware’s doctrine of internal affairs (which governs choice of law issues) should have been applied.  The Court disagreed and found that the pre-suit demand requirement is a matter of internal affairs because it serves a core function of substantive corporation law by allocating, as between directors and stockholders, the authority to sue on behalf of the corporation.  Finally, the Court rejected plaintiff’s third argument that public policy favored application of Delaware law.  The Court agreed with the plaintiff that Delaware has a strong interest in policing alleged breaches of fiduciary duties, but found that Delaware courts could only fulfill that role where their power to act was first be properly invoked.

Advice of Counsel is not Outcome Determinative in Establishing Fair Dealing.

In Encite, LLC v. Soni, C.A. No. 2476-VCG (Del. Ch. Nov. 28, 2011), the Delaware Court of Chancery denied defendant directors’motion for summary judgment on the issue whether they conducted an entirely fair auction process for the sale of a now-defunct technology start-up, Integrated Fuel Cells Technologies, Inc. (“Integrated”), where the defendants relied largely on the defense that they had solicited and followed the advice of counsel.  Integrated was a venture-backed company founded by Stephen Marsh (“Marsh”) which entered into an auction process to avoid bankruptcy.  The Integrated board, which was comprised of Marsh, a Marsh designee, two designees of Echelon Ventures L.P. (“Echelon”), its largest investor, and an independent director, did not hire an investment advisor to conduct the auction, but did manage to solicit some interest, including an Echelon-backed bid and a Marsh-backed bid.  Ultimately, the board approved the Echelon-backed bid, and Marsh sent an e-mail to all stockholders that the board was conflicted and had ignored superior offers.  After several stockholders brought derivative claims, all members of the Integrated board resigned other than Marsh, who then abandoned the auction and entered the company into bankruptcy.  A Marsh affiliate then purchased Integrated’s assets in bankruptcy and brought this action against the former Integrated directors other than marsh.  Plaintiff alleged that defendants breached their fiduciary duties in approving the unconsummated transaction with an Echelon affiliate—essentially asking the Court to determine whether the defendants squandered an opportunity to realize the true value of the company by attempting to force through an inferior transaction in which they were interested.  On this motion for summary judgment, defendants asked the Court to find that their actions passed muster under the exacting entire fairness standard of review applicable to interested transactions.  The Court denied the motion on the basis that defendants had not set forth any evidence from which it could make that decision. Instead, the defendants relied on conclusionary statements that the process had been fair because their counsel told them it was a fair process.  The Court noted that reasonable reliance on expert counsel is a pertinent factor in evaluating whether corporate directors have met a standard of fairness in their dealings with corporate powers; however, its existence is not outcome determinative.  The Court also expressed doubts about plaintiff’s ability to demonstrate damages at trial given the Court’s determination that the proper measure of damages would be the difference between Integrated’s value before the defendants resigned as directors and the value achievable by Marsh afterwards.  Finding that Marsh was not required to abandon the auction or cause Integrated to enter into bankruptcy (i.e., he could have sold the assets for more) the Court rejected Marsh’s argument that the measure of damages should be the difference between what plaintiff paid for the assets in bankruptcy and the assets highest value during the bidding process.

Earn-Out Payments in Merger Agreements and the Implied Covenant.

In Winshall v. Viacom Int’l, Inc., C.A. No. 6074-CS (Del. Ch. Nov. 10, 2011), the Delaware Court of Chancery rejected plaintiff’s argument that both the seller and the acquirer of a business possessed an affirmative duty under the implied covenant of good faith and fair dealing to take an opportunity to increase the potential earn-out payments to the seller’s stockholders under a merger agreement in which the stockholders possessed no reasonable expectancy interest.  In 2006, defendant Viacom International (“Viacom”) acquired defendant Harmonix Music Systems, Inc., a creator of music-oriented gaming systems (“Harmonix”).  Under a merger agreement entered into among Viacom, Harmonix and certain Harmonix stockholders in 2006, Harmonix’s stockholders were entitled to receive an up-front cash payment for their shares, as well as a contingent right to receive uncapped earn-out payments based on Harmonix’s financial performance in the two years following the merger, 2007 and 2008. About one year after the merger closed, Harmonix released a new video game, which was very successful, and Harmonix renegotiated an existing contract it had with a third party for the distribution of the game.  As part of the renegotiation, Harmonix was able to obtain a wider distribution of its product and a reduction in distribution fees, in upcoming years, following the expiration of the earn-out period.  In this action, plaintiff alleged that the defendants breached the implied covenant of good faith and fair dealing by not negotiating for a reduction in distribution fees during the earn-out period.  The Court found inequitable the proposed imposition of a duty on the defendants to share with Harmonix’s stockholder the benefits of a renegotiated contract addressing distribution rights after the expiration of the earn-out period.  According to the Court, the implied covenant of good faith and fair dealing requires a party to refrain from conduct that is contrary to the fundamental expectations of the other party as implied by the explicit terms of the deal.  In this case, plaintiff sought to actually expand “its contractual counterparty’s expectancy as a matter of judicially compelled charity, not toward a 501(c)(3), but toward another sophisticated commercial actor.” Slip. Op. at 21.  Accordingly, the Court dismissed plaintiff’s complaint.

These case summaries are intended for informational purposes only.

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The Delaware Counsel Group LLP (“DECG”) represents national and international clients in complex transactional and governance matters involving Delaware business entities.  Through DECG’s exclusive focus on Delaware corporate, alternative entity and commercial law, the firm has the expertise to guide and advise law firms, in-house counsel and business people regarding sophisticated Delaware legal issues.  As a result of DECG’s personalized, hands-on, team-oriented approach to lawyering, the firm’s clients find that their liability is reduced, time and money is saved, and long-term relationships that foster mutual growth opportunities are built.