The Right to Remove Directors “With or Without Cause” Cannot Be Contractually Eliminated But For Two Limited exceptions
In In re Vaalco Energy Shareholder Litigation., a bench ruling, the Court of Chancery invalidated provisions found in the certificate of incorporation and bylaws of a Delaware corporation that permitted directors to be removed only “for cause”. Generally, the Delaware General Corporation Law (“DGCL”) allows directors to be removed “with or without cause”. However, if the board of directors is classified or shareholders are given cumulative voting rights in director elections, the directors’ removal may be conditioned upon “cause”. In this case, neither exception was present. Relying on the plain language of the DGCL, the Court invalidated the “for cause” only provisions, despite the defendant corporation’s argument that many other companies utilized similar provisions.
Bottom Line: Unless a Delaware corporation has a classified board or provides shareholders with cumulative voting rights, it may not contractually require that directors be removed only “for cause”. Companies should review their organizational documents and modify them accordingly.
The Court of Chancery was asked to interpret a “Put Right” provision (the “Put Right”) in an LLC Operating Agreement, which provided:
“During the period that is between 30 days and 60 days following March 14, 2014, each Rollover Investor may elect to deliver a written notice . . . to the Company and the Investor of its desire to require the Company (and the Investor as contemplated by Section 9.2(d)) to purchase all (but not less than all) of the Preferred Units held by such Rollover Investor . . . .”
Upon exercise of the Put Right, the Company was required to engage “a nationally recognized valuation firm . . . to determine the Fair Market Value of the Put Units as determined by the Valuation Firm in accordance with [the LLC Operating] Agreement” (the ‘Put Price’) . . . .” The LLC Operating Agreement also stated that the Company and the Rollover Investors “shall be bound by the determination of the Valuation Firm . . . with respect to the Put Price as established by the Valuation Firm . . . .”
The Rollover Investors exercised the Put Option within the applicable window, but after the Put Price was determined, they challenged the Valuation Firm’s results. The court rejected the Rollover Investors’ arguments, finding that the LLC Operating Agreement foreclosed any possibility of an appeal, and that they were contractually bound to accept the valuation.
Bottom Line: LLC members seeking a put right should require that the put right provision include an option to seek judicial review if they disagree with the agreed upon valuation firm’s decision. Stating that both parties “shall be bound” by the valuation firm’s determination, without any mention of judicial review, will moot any challenge of the reasonableness of the valuations firm’s judgment calls.
Bad Business: The Term “Business” in an Indemnification Provision is Only as Broad as its Definition
The Court of Chancery examined the following indemnification language in an LLC Operating Agreement: The Company shall “indemnify each Manager for all costs, losses, liabilities and damages paid or incurred by such Person in connection with the business of [the Company] to the fullest extent provided or permitted by the [Delaware Limited Liability Company] Act and the other laws of the State of Delaware.” The court interpreted this language broadly, and found that if the company wished to narrow the scope of the term “business” to include only “those matters that directly generate income,” it should have defined the term as such in the LLC Operating Agreement. The Court thus granted indemnification and advancement to the claimant manager.
Bottom Line: Undefined terms in advancement and indemnification provisions will be left to the discretion of the courts. A party that wishes to narrow the scope of its “business” for the purposes of indemnification and advancement must do so expressly within the provision, or the “Definitions” section of the LLC Operating Agreement.
Buyers Beware: A closing conditioned on the absence of threatened litigation Does Not protect from the reservation of potential litigation
The Court of Chancery examined a closing condition that there be “no pending or threatened legal or administrative action” related to an Equity Purchase Agreement pursuant to which the buyer agreed to purchase the seller. Immediately before closing, the Pension Benefit Guaranty Corporation (the “PBGC”) wrote a letter to the seller noting its concern regarding the seller’s transfer to the buyer of certain pension plan obligations. After the transaction closed, the PBGC sent another letter advising the seller that it was “extremely disappointed” that is had closed the transaction and that, while it did “not plan to initiate legal action against [the seller], [it had] not yet decided whether [it would] pursue [the] matter through the IRS and/or professional actuarial organizations.” The Court found that this language was not a “threatened legal or administrative action,” but rather “merely an identification or a reservation of options . . . .”
Bottom Line: “Potential Litigation” is not the equivalent of Threatened Litigation.” When potential litigation exists pre-closing, buyers should condition closing on receipt of a no-action letter from each potential claimant.
The Court of Chancery dismissed claims of fraud in connection with the sale of a portfolio company from one private equity firm to another. The buyer claimed that the seller made extra-contractual false representations in both oral and written communications. The court determined that, notwithstanding the validity of the fraud claims, such claims were foreclosed by the exclusive representations clause found in the Stock Purchase Agreement. The provision read, in pertinent part:
“[THE] REPRESENTATIONS AND WARRANTIES [FOUND WITHIN THIS AGREEMENT] CONSTITUTE THE SOLE AND EXCLUSIVE REPRESENTATIONS AND WARRANTIES . . . TO THE BUYER IN CONNECTION WITH THE TRANSACTION, AND THE BUYER UNDERSTANDS, ACKNOWLEDGES, AND AGREES THAT ALL . . . REPRESENTATIONS AND WARRANTIES OF ANY KIND OR NATURE EXPRESS OR IMPLIED (INCLUDING, BUT NOT LIMITED TO, ANY RELATING TO THE FUTURE OR HISTORICAL FINANCIAL CONDITION, RESULTS OF OPERATIONS, ASSETS OR LIABILITIES OR PROSPECTS [OF SELLER]) [NOT EXPRESSLY SET FORTH HEREIN] ARE SPECIFICALLY DISCLAIMED BY THE [SELLER] PARTIES.”
Bottom Line: Contractual freedom trumps misrepresentations. Parties can foreclose extra-contractual fraud claims by negotiating for an exclusive representations clause. Delaware courts will uphold an unambiguous exclusive representations clause accompanied by an integration clause, even if fraudulent misrepresentations are sufficiently alleged.
The Delaware Court of Chancery weighed the policy of resolving all claims related to a dispute in the court in which an action is first filed against Delaware’s policy of summarily resolving advancement claims. The Court denied a request for a stay because it found no “particularly compelling explanation as to why” the advancement claim, which derived from advancement rights set forth in a limited liability company agreement, should be delayed.
Bottom Line: Delaware’s strong policy favoring the prompt resolution of advancement proceedings applies to rights provided in alternative entity organizational documents as well as rights available under corporate statute.
The Delaware Supreme Court confirmed that a minority-shareholder’s challenge to a “going private” transaction will be reviewed under the business judgment standard rather than the more demanding entire fairness standard of review if the following six factors are satisfied:the controller conditions the procession of the transaction on the approval of both a Special Committee and a majority of the minority stockholders;
- the controller conditions the procession of the transaction on the approval of both a Special Committee and a majority of the minority stockholders;
- the Special Committee is independent;
- the Special Committee is empowered to freely select its own advisors and to say no definitively;
- the Special Committee meets its duty of care in negotiating a fair price;
- the vote of the minority is informed; and
- there is no coercion of the minority.
Bottom Line: Utilization of these protections will likely result in dismissal on the pleadings of a minority shareholder’s claims against a controlling shareholder in both the public and private company context. To avoid the discovery costs associated with defending against a minority shareholder’s claims, the transaction should always be conditioned upon the vote of a special committee and a majority of the minority stockholders.
Defective Acts Taken By Former Directors and Stockholders May be Ratified By Action of the Current Directors and Stockholders
The Delaware Supreme Court recently upheld an order of the Court of Chancery that clarified the capital structure of the corporation at issue. The decision is the result of “one of the first uses by litigants of new” Sections 204 and 205 adopted in 2014 and amended in 2015. These sections provide viable options to ratify defective acts. Section 204 authorizes ratification by the board of directors and, if applicable, the stockholders of a corporation. Section 205 authorizes the court to consider the validity of corporate acts of questionable validity. However, as illustrated in In Re Numoda Corporation, proceedings in the Court of Chancery with respect to ratification can be time consuming and expensive.
Bottom Line: Although Sections 204 and 205 are tremendous tools, it would be wise to avoid having to rely on ratification in lieu of adhering to corporate formalities through the life of the company. If a court is asked to act under Section 205, there will be more at issue than whether the “defective act” was meant to be taken.
The Delaware Supreme Court recently clarified several points of Delaware law when it affirmed the dismissal of a lawsuit challenging the entire fairness of an acquisition. The court found that:
- A stockholder cannot be deemed to have “effective control” of the company if (a) the stockholder owns less than 1% of a corporation’s shares of stock and (b) has limited contractual control over the management of the corporation.
- When a transaction is not subject to the entire fairness standard and is approved by a fully informed, uncoerced vote of the disinterested shareholders, the business judgment rule applies.
- In a post-closing money damages claim, it is the Court’s analysis of the informed and uncoerced shareholder vote that controls, regardless of whether or not Revlon applied to the transaction.
- Delaware courts will not presume the validity of a shareholder vote, but will perform a thorough analysis to determine the vote was informed and uncoerced.
Bottom Line: When a closed transaction is challenged, the business judgment standard of review will apply unless the shareholder vote was tainted by coercion or the shareholders were uninformed.
If You Want to Provide Former Corporate Officials with the Right to be Advanced Expenses, Provide for it in the Corporation’s Certificate of Incorporation or Bylaws
The Court of Chancery denied advancement to former officers and directors of two Delaware corporations. These cases make clear that in order to provide advancement both during and after a person’s corporate role has ended, the Certificate of Incorporation or the Bylaws of the corporation must explicitly provide such right. Further, a corporation may not eliminate the requirement that a person must be entitled to indemnification and/or advancement only if the claim brought is “by reason of” the fact that the person was a corporate official.
Bottom Line: Explicitly identify the persons entitled to advancement in the advancement provisions even if advancement terms are accompanied by terms granting indemnification “to the fullest extent permitted by Delaware law”.
A stockholder owning well less than a majority of stock can be found to be a controlling stockholder if the person or entity exercises significant decisional control over the company
The Court denied a motion to dismiss brought against the individual members of the board of a Chinese company. Plaintiffs, the public stockholders, alleged that the process by which the CEO purchased all the outstanding shares was unfair, and that they did not received an adequate price for their stock. The case survived the motion despite the fact that the going-private merger was negotiated by an independent special committee of the board and was approved by a slim majority of unaffiliated stockholders. Delaware evaluates motions to dismiss under a “reasonably conceivable” pleading standard that draws all inference in favor of the plaintiff. Under this standard, the Court found that the plaintiffs had sufficiently alleged that the CEO was a de facto controlling shareholder despite his holding a mere 17.3 percent of the company’s stock. Among other facts in the complaint, the Court noted 10-K filings that disclosed the CEO’s influence over major company decisions, as well his insistence on an allegedly low price early in the process, from which he refused to deviate. The stockholders claimed that this price was below the even the low end of ranges arrived at using various valuation methodologies. In addition, the CEO refused to cooperate with any third-party bidders. The Court found it reasonably conceivable that this had chilled the special committee’s ability to secure a higher per-share price. All these factors led the Court to conclude that the plaintiffs had sufficiently pleaded that the CEO was a controlling stockholder, which shifted the standard of review of the transaction to entire fairness, which precluded dismissing the case at such an early stage.
No post-merger obligation can be imposed on stockholders that interferes with their ability to determine the amount of the merger consideration
The plaintiff’s motion for judgment on the pleadings was granted in part and denied in part. The plaintiff challenged a number of conditions imposed on their receipt of consideration for a merger: 1) to release all claims against the merged corporation; 2) an indemnification obligation; and 3) the use of a certain stockholders’ representative. The Court found the release obligation invalid because this condition was found only in the letter of transmittal to be executed upon transfer of the merger consideration. The release was not included in the merger agreement. The Court found therefore that the release was a condition imposed without consideration, because the merger price had already been set by the merger agreement. If it was found valid, “buyers could impose almost any post-closing condition or obligation on the target company‘s stockholders after the fact by including it as a requirement in the letter of transmittal.” The indemnification obligation was also found invalid, even though it was detailed in the merger agreement, because it violated Delaware General Corporation Law §251(b). No amount was set aside to satisfy the obligation, as it would be with an escrow structure, and no time limit was placed on potential claims. This left it impossible for stockholders to know what they would ultimately receive as consideration for the merger, and the Court stated that §251 “requires a merger agreement to set forth determinable merger consideration.” The Court imposed the requirement of a monetary cap and a time limit of 36 months or less, but it also stressed the limits of the holding, stating that it “does not concern escrow agreements, nor does it rule on the general validity of post-closing price adjustments requiring direct repayment from the stockholders.” As for the third challenged obligation, the Court held that the plaintiff failed to address adequately the question regarding the stockholder representative.
Even weak evidence may subject a foreign entity to jurisdiction of the Delaware Courts under the long-arm stature at the motion to dismiss stage
The Court denied a motion to dismiss a suit against an Italian company and two Italian citizens. The dispute involved a Delaware limited liability company formed to take commercial advantage of Russian satellite orbital slots. The plaintiff alleged that the Italian company and the two individual defendants conspired to misappropriate the business opportunities of the LLC. The Court held the plaintiff pleaded sufficient facts to satisfy the five-part test required to establish personal jurisdiction based on conspiracy theory. The opinion noted, however, that at the motion to dismiss stage, all inferences must be drawn in favor of the plaintiff. The five-part test was taken from Istituto Bancario Italiano SpA v. Hunter Eng’g Co., 449 A.2d 210, 222 (Del. 1982). The Court found the plaintiff sufficiently alleged, first, that a conspiracy to defraud existed because he presented circumstantial evidence that two or more people had a meeting of the minds in pursuit of a goal, and that their actions included an unlawful act that damaged the plaintiff. In this case the unlawful act was the formation of the Delaware holding company that acquired the LLC and thereby took control of it. The plaintiff also sufficiently alleged that: Second, all defendants were members of that conspiracy because it could be inferred that the conspiracy served their interests; third, that the formation of the holding company was a substantial act in furtherance of the conspiracy that occurred in the forum state; fourth, the Italian entity knew or had reason to know about the formation of the holding company; and fifth, the act in the forum state was a direct and foreseeable result of the conduct in furtherance of the conspiracy because the formation of the holding company was an intentional act.
The Delaware Supreme Court affirmed a Court of Chancery decision that held a corporate director’s oral resignation to be valid under 8 Del. C. § 141(b). 8 Del. C. § 141(b) provides that “[a]ny director may resign at any time upon notice given in writing or by electronic transmission to the corporation.” The appellant in this action argued for a strict interpretation of this language and urged the Supreme Court to adopt a special standard of review when evaluating whether a director resigned by oral statement or by other conduct.
The Supreme Court, however, found that the plaintiff’s claim lacked merit. The Court pointed out that the Court of Chancery has long-held that the word “may” in 8 Del. C. § 141(b) is permissive and authorizes a director to resign by oral statement. In reaffirming this sound interpretation, the Supreme Court recognized that since the Court of Chancery’s reading of the statute was announced in 1984, the General Assembly had amended the statute numerous times without ever signaling any disagreement with the interpretation. The Court also found that the Court of Chancery was well equipped and clearly qualified to resolve complex corporate cases involving the composition of a board of directors. Accordingly, the Supreme Court held that a special standard of review was unnecessary and that the director’s oral resignation was valid.
A Company May Not Restrict the Ability of a Shareholder to Trade Stock as a Condition to Inspect Corporation’s Books and Records
This case revolved around a Delaware corporation’s denial of a shareholder request to provide the shareholder with the company’s updated non-public financial statements. The plaintiff-shareholder, in accordance with 8 Del. C. § 220, demanded to inspect the company’s financial statements for the purpose of “determining the value of its investment and the economic performance” of the defendant-company. In response, the defendant informed the plaintiff that the only way it would disclose the financial statements was if the plaintiff agreed to be bound by a restriction forbidding it to trade the company’s stock after it received the information. The defendant, whose stock traded on the over-the-counter-market, was concerned that disclosing such “material, non-public” information would violate federal securities law. The plaintiff, however, refused the restriction and filed suit to compel disclosure of the financial statements.
In deciding this case, the Court of Chancery was faced with a novel question of Delaware law: whether a Delaware corporation may require a shareholder to agree not to trade in its stock as a condition precedent to inspect its nonpublic financial statements. The Court answered this question in the negative, and in doing so, emphasized the fact that Delaware has “long recognized that valuing stock is a proper purpose to support” a request for financial statements. It further found that because that was the primary purpose of the plaintiff’s request, any secondary purpose for obtaining the financial information was irrelevant. Based on this reasoning, the court struck down the defendant’s restriction.
In this opinion, the Court of Chancery addressed the power of “de facto” directors to remove a properly elected director of a non-profit Delaware corporation. After being removed as a director in accordance with the company’s bylaws, the plaintiff brought suit alleging, inter alia, that his removal was void because three of the directors who voted in favor of his removal were “not validly seated on the board” due to procedural defaults in their election. In addressing this argument, the Court found that even if the three board members were invalidly elected, they were “de facto” directors and thus still capable of taking enforceable actions. The Court, affirming precedent, explained that a “de facto” director is one “‘in possession of and exercising the powers of that office under claim and color of an election, although . . . not a director [d]e jure and [removable] by proper proceedings.’” The Court stated that although “de facto” directors were potentially removable, any prior, otherwise valid actions they had taken were enforceable as a matter of law. Accordingly, the court dismissed the plaintiff’s argument and upheld the director’s removal.
In this case, the Delaware Supreme Court provided answers to four certified questions of law from the U.S. District Court for the District of Delaware regarding the validity of an intra-corporate fee-shifting provision in the bylaws of a Delaware non-stock corporation, ATP Tour Inc. (“ATP”). The fee-shifting provision at issue was adopted in the discretion of the Board and required any ATP member who unsuccessfully brought an action against ATP or any ATP member to pay for the prevailing party’s legal costs and fees. The provision generally provided:
In the event any . . . member or Owner or anyone on their behalf . . . asserts any claim or counterclaim . . .or joins, offers substantial assistance to or has a direct financial interest in any Claim against the League or any member or Owner (including any Claim purportedly filed on behalf of the League or any member), and the Claiming Party . . . does not obtain a judgment on the merits that substantially achieves, in substance and amount, the full remedy sought, then they shall be obligated jointly and severally to reimburse the League and any such member or Owners for all fees, costs and expenses of every kind and description (including, but not limited to, all reasonable attorneys’ fees and other litigation expenses) . . . that the parties may incur.
Thereafter, ATP members brought suit against ATP and six of its Board members in District Court and lost on the merits of their claims. When ATP moved to recover its legal fees and costs under the company’s fee-shifting bylaw, the District Court certified questions regarding the validity of such a bylaw to the Delaware Supreme Court. In addressing the questions, the Court held that a bylaw provision providing for fee shifting in intra-corporate disputes is facially permissible as it is consistent with the Delaware General Corporate Law. The Court cautioned, however, that whether the specific ATP bylaw would be enforceable depended on whether it was adopted for a proper purpose, and that the intent to deter litigation may qualify as such a purpose.
In Third Point LLC v. Ruprecht, the Delaware Court of Chancery refused to preliminary enjoin Sotheby’s annual meeting based on shareholder claims that Sotheby’s Board had breached its fiduciary duties by adopting a two-tiered Shareholder Rights Plan (the “Rights Plan”). Sotheby’s adopted the Rights Plan, or poison pill, in response to “rapidly” increasing hedge fund activity in its stock. Under the terms of the Rights Plan, passive investors who reported their ownership in the company pursuant to Schedule 13G were permitted to acquire up to a 20% interest in Sotheby’s. All other investors, such as the Plaintiff, who filed a Schedule 13D to report their ownership interest could only acquire a 10% stake in the company before triggering the Rights Plan. In bringing suit, the Plaintiff argued that Sotheby’s Board improperly adopted the Rights Plan for the primary purpose of inhibiting its ability to wage a successful proxy contest without any compelling justification for doing so.
Applying the Unocal standard of review, the Delaware Court of Chancery found that Sotheby’s Board, comprised of a majority of independent directors, had not breached its fiduciary duties and denied the Plaintiff’s motion for preliminary injunction. The court reasoned that the rapid rise in stock accumulation by several hedge funds provided reasonable grounds for the Board to determine that the hedge funds posed a legally cognizable threat of acquiring a controlling interest in the company without paying a control premium. The court further held that the Rights Plan was a proportionate response to the threat and was enacted only after proper consideration by Sotheby’s Board.
Public v. Private Auctions: Determining Which Option Maximizes Company Value in an LLC Dissolution Procedure
In this case, the Delaware Court of Chancery was asked to decide the best method of effectuating the dissolution and liquidation of a deadlocked LLC. Although the parties could have crafted a specific procedure to govern the dissolution in the LLC Agreement, they failed to do so. Thus, the choice of dissolution procedure was left to the discretion of the court. Petitioners asked that the court require the LLC to be sold in a private auction open only to the LLC’s members and a specific labor union. Respondents, also members of the LLC, preferred that the LLC be sold in a public auction to account for possible third party interest. In addressing the dispute, the court first recognized that there “is no single blueprint” under Delaware law for maximizing the value of an entity through sale. “Therefore, determining the value maximizing process by which an entity should be liquidated is both a fact-intensive and fact-specific endeavor.”
Applying this standard, the court found that no “serious” third party public bidder was likely to emerge, and thus, a private auction was proper. The court based its conclusion on the fact that the potential sale of the LLC had been public knowledge for months, but the Respondents were unable to point to one interested third party bidder. Although there had been previous interest from six third party bidders, each of them withdrew their interest once they saw the LLC’s financials. The court also noted that because the parties agreed that the company would be sold “as is,” with no representations or warranties, a third party buyer was very unlikely to acquire the company on such a “decidedly seller-friendly basis.” With no third party likely to emerge, the court found that utilizing a private auction would be the faster and less expensive option.
A Board Need Not Obtain a Fairness Opinion When Effectuating a Merger to Comply with the Duty of Loyalty
This case involved a suit brought by two shareholders of Universata, Inc., a Delaware corporation. In 2009, the Plaintiffs sold their business to Universata for approximately $9 million, to be paid over a seven-year period. When Universata began having difficulty making the payments, it transferred 525,000 shares of its common stock to the Plaintiffs in exchange for a portion of its debt. In 2011, Universata’s board of directors (the “Board”) approved a merger in which its shareholders were to receive a total of approximately $1.19 per share. Although the Board hired an investment bank to assist with due diligence, it decided against obtaining a formal fairness opinion. After the merger closed, the Plaintiffs refused to tender their shares and filed suit in the Court of Chancery alleging, inter alia, that the Board had breached its fiduciary duty of loyalty.
In dismissing the Plaintiffs’ claim, the court reiterated the standard necessary to find a breach of the duty of good faith, stating: “a breach of the duty of good faith may be implicated either by a board’s utter failure to attempt to satisfy its fiduciary duties, . . . or by its ‘intentionally act[ing] with a purpose other than that of advancing the best interests of the corporation,’ for example by acting out of greed, hatred, lust, envy, revenge, shame, pride, or some other ‘human motivation.’” The court found that although the sales process was not perfect, the Board “did [not] utterly fail to undertake any action to obtain the best price for stockholders.” The court reasoned that the Board consulted legal counsel, contemplated, and rejected based on cost, obtaining a fairness opinion, hired an investment bank to assist in shopping the company, and considered bids from multiple bidders. Accordingly, the facts alleged fell short of demonstrating bad faith.