On May 14, 2015, the Delaware Supreme Court clarified that, even in conflict-of-interest transactions subject to “entire fairness” review, breach of fiduciary duty claims against independent, disinterested directors should be dismissed at the pleading stage where a complaint fails to allege a non-exculpated breach. See In re Cornerstone Therapeutics, Inc. S’holder Litig., Case No. 564, 2014; Leal, et al. v. Meeks, et al., Case No. 706, 2014 (Del. May 14, 2015). The Court’s decision resolves two separate consolidated appeals by outside directors of Cornerstone Therapeutics, Inc. and Zhongpin, Inc. (For a discussion of the Chancery Court’s Zhongpin decision, see Jason M. Halper, et al., Delaware Court Determines That 17.5% Stockholder Seeking to Take Company Private Could Be Deemed a Controller, The M&A Lawyer, Jan. 2015, Vol. 19, Issue 1.) In each case, the Chancery Court denied the independent directors’ motions to dismiss, even though there were no allegations that those directors committed a breach of loyalty or acted in bad faith such that the companies’ Section 102(b)(7) charter provisions would not apply. Instead, those courts held that “entire fairness” review effectively precludes dismissal of breach of fiduciary duty claims at the pleading stage based on a Section 102(b)(7) charter provision. The Supreme Court’s rejection of these decisions potentially offers significant protections to independent directors tasked with deciding whether to approve transactions involving interested directors.
The facts underlying the appeals in Cornerstone and Zhongpin are substantially similar. In each case, the company’s controlling stockholder proposed a buy-out and a special committee of disinterested directors was formed to evaluate the proposal. Each special committee retained independent legal and financial advisors, performed a market check, and ultimately approved the transaction. A majority of each company’s minority stockholders voted in favor of the transactions, but, nonetheless, stockholders filed suit challenging the transactions as not “entirely fair.” Both companies’ certificates of incorporation contained Section 102(b)(7) charter provisions, which exculpated directors from money damages for claims for breach of fiduciary duty, except for breaches of the duty of loyalty or acts of bad faith. The independent directors filed motions to dismiss on the ground that the stockholders’ complaints did not allege that they committed any non-exculpated breach of duty.
In each case, the Delaware Court of Chancery denied the directors’ motion to dismiss, but also certified its opinions for interlocutory appeal to the Delaware Supreme Court. In its opinion, the Delaware Supreme Court agreed with the independent directors, holding that “[a] plaintiff seeking only monetary damages must plead non-exculpated claims against a director who is protected by an exculpatory charter provision to survive a motion to dismiss, regardless of the underlying standard of review for the board’s conduct—be it Revlon, Unocal, the entire fairness standard, or the business judgment rule.”
Takeaways and Analysis
- While the appellants in Zhongpin and Cornerstone focused their appeal on the “entire fairness” standard of review in a controlling stockholder transaction, the Court’s holding applies outside controller transactions.
The Court’s holding applies regardless of whether a stockholder challenge involves director approval of a sale of the company, implementation of takeover defenses, or a controlling stockholder transaction. In any of these scenarios, claims against independent and disinterested directors must be dismissed at the pleading stage pursuant to a Section 102(b)(7) charter provision where the complaint fails to plead facts supporting an inference that directors breached their duty of loyalty or acted in bad faith.
Key to this analysis, however, is the absence of allegations casting doubt on the independence and disinterest of outside directors. Thus, for example, a motion to dismiss will be denied “when a complaint pleads facts creating an inference that seemingly independent directors approved a conflicted transaction for improper reasons” in breach of their duty of loyalty. It also follows that such a charter provision will not assist interested directors, “often the proverbial deep-pocketed defendants, [who] will continue to be required to prove that the transaction was entirely fair to the minority stockholders.”
- In its opinion, the Court explained that “each director has a right to be considered individually when the directors face claims for damages in a suit challenging board action,” and under Delaware law, directors are presumed to be independent and to have acted in good faith and in the corporation’s best interests. Adopting the Chancery Court’s rule, the Supreme Court explained, would be inconsistent with this central tenet of Delaware corporate law.
The Court’s decision reflected its respect for director independence and the potential harmful consequences of adopting the Chancery Courts’ holding. As the Supreme Court explained, “although it is wise for [Delaware] law to focus on whether the independent directors can say no, it does not follow that it is prudent to create an invariable rule that any independent director who says yes to an interested director transaction subject to entire fairness review must remain as a defendant until the end of the litigation, regardless of the absence of any evidence suggesting that the director acted for an improper motive.” The Court added that it was declining to “adopt an approach that would create incentives for independent directors to avoid serving as special committee members, or to reject transactions solely because their role in negotiating on behalf of the stockholders would cause them to remain as defendants until the end of any litigation challenging the transaction.”
- The Court’s decision further highlights the importance of director liability protection provisions in corporate charters.
Without the benefit of a Section 102(b)(7) charter provision exculpating them from monetary liability for breaches of the duty of care, directors will not benefit from the Court’s decision. Directors, particularly those serving on special committees evaluating interested party transactions, should ensure that they are protected by a Section 102(b)(7) charter provision. Nonetheless, directors should be mindful that the Court’s decision only applies to claims seeking monetary damages. If the plaintiffs have asserted a claim for injunctive relief, directors will not be entitled to dismissal at the pleading stage by relying on an exculpatory charter provision, even if there are no allegations that they breached their duty of loyalty or acted in bad faith.
 See In re Zhongpin, Inc. S’holders Litig., Consol. C.A. No. 7393-VCN, 2014 WL 6735457 (Del. Ch. Nov. 26, 2014); In re Cornerstone Therapeutics, Inc. S’holder Litig., C.A. No. 8922-VCG, 2014 WL 4418169 (Del. Ch. Sept. 10, 2014).