Chancery Court Provides Additional Room for Shareholders Challenging Change of Control Transactions

What you need to know:

In its recent decision in Chen v. Howard-Anderson, Delaware’s Court of Chancery held that directors and officers may be found to have acted in bad faith, thereby breaching their fiduciary duty of loyalty, if, in a change of control transaction, they act with a purpose other than pursuing the highest value reasonably obtainable for the company’s shareholders.  The decision expands upon the Delaware Supreme Court’s 2009 decision in Lyondell Chemical Co. v. Ryan, which held that directors and officers may be held personally liable for breaching their duty of good faith, and therefore loyalty, if they consciously disregard known obligations.  The Lyondell Court defined conscious disregard as knowingly and completely failing to undertake one’s responsibilities, which, in the sales process context, translates to utterly failing to attempt to obtain the best sale price.  Many practitioners viewed Lyondell as defining the limits of breach of duty of loyalty claims in sale transactions, and setting an extremely high bar for plaintiffs seeking to bring such claims.  In recognizing an additional bad faith theory outside the scope of Lyondell, Chen reaffirmed that Delaware courts view duty of loyalty claims as requiring case-by-case assessment.  The Court’s ruling in Chen means that shareholders seeking to challenge sale transactions will increasingly argue that officers and directors were influenced by factors other than obtaining the highest price for shareholders.

What you need to do:

As always, directors and officers involved in evaluating change of control transactions must attempt to obtain the best price reasonably available.  After Chen, they should ensure that their decision-making process is not susceptible to any argument that they were motivated by other considerations.  Depending upon the circumstances, use of a special committee, an outside financial advisor and a structured, well-documented process may be useful in defending against such claims.  Chen also teaches that once identified, bona fide alternative bidders must be provided with a reasonable opportunity to respond, and that 24 hours is not reasonable.    

During 2009 and 2010, Occam Networks, Inc., a broadband access company, explored various strategic alternatives that ultimately resulted in its sale to Calix, Inc. In Chen, plaintiff shareholders of Occam alleged that the directors and officers of the company breached their fiduciary duties during the sale process by unreasonably favoring Calix over other potential buyers and by failing to pursue other potentially value-maximizing alternatives.  The plaintiffs also alleged that the proxy statement issued in connection with the sale contained materially misleading information regarding actions taken by the defendants during the sale process.  Following protracted discovery, the defendants filed a motion for summary judgment in which, relying on Lyondell, they asked the court to rule that they did not breach their fiduciary duties and, in the alternative, that even if the evidence could support a breach of the duty of care, they could not be held liable due to the exculpatory provisions of the company’s charter.

The Court applied the enhanced scrutiny standard of review, which entails judicial examination of the reasonableness of the Board’s decision-making process.  Viewing the facts in the light most favorable to the plaintiffs, the Court found that the record supported a reasonable inference that the defendants acted unreasonably during the sale process by favoring a sale to Calix at the expense of generating greater shareholder value.  In support of their sale process claims, the plaintiffs cited, among other things, the Board’s 24-hour revised-bid ultimatum to a potential buyer, as well as the Board’s reliance on a 24-hour “market check” conducted by Jefferies as evidence of the defendants’ unreasonable conduct.  The Court agreed that these actions could readily be seen as outside the range of reasonable conduct, constituting a breach of the duty to exercise due care.

Turning to the duty of loyalty, the Court examined the plaintiffs’ claim that the defendants had acted in bad faith.  The plaintiffs argued that the Court could draw an inference of bad faith from the sale-process conduct that fell outside the range of reasonableness.  The defendants argued that Lyondell was dispositive and precluded this claim because the plaintiffs did not allege that the defendants had utterly failed to attempt to fulfil their fiduciary duties.  The Court disagreed with the defendants’ reading of Lyondell and found that the plaintiffs’ bad faith theory fell outside the scope of the Lyondell decision, which addressed bad faith based on conscious disregard of known responsibilities.  Thus, the Court read Lyondell as applying only to one category of bad faith claims as opposed to defining the parameters of all possible bad faith claims.

The Court held that the plaintiffs could defeat summary judgment with respect to bad faith-based claims by showing that directors made decisions during the sale process that fell outside the range of reasonableness for reasons other than maximizing shareholder value.  However, the Court found that the plaintiffs had failed to produce evidence showing that a majority of the directors were not independent and disinterested, or that the outside directors’ conduct was motivated by something other than pursuit of the best available sale price.  In contrast, the Court found that the record supported a reasonable inference that the insider director and officer defendants were motivated by personal financial interests.  Thus, viewing the facts in the light most favorable to the plaintiffs, the record supported the plaintiffs’ bad faith-based breach of fiduciary duty claim as to certain of the defendants.  With respect to the outside director defendants, however, the record only supported the inference that they had breached their duty of care, and not the inference that they had breached their duty of loyalty by acting in bad faith.

Although the Court found that the record created a triable issue of fact on the question of whether the directors exercised due care, personal liability for breach of the fiduciary duty of due care was barred by the exculpatory provision of the Company’s charter.  However, under Section 102(b)(7) of the Delaware General Corporation Law, such protection does not extend to a company’s officers.   The Court therefore granted summary judgment for the director defendants and denied summary judgment for the officer defendants.