CDX Holdings, Inc. v. Fox: Chancery Court’s Decision Is Affirmed, But Dissent Blasts Use of “Hindsight Bias” Analysis


On June 6, 2016, the Supreme Court of Delaware affirmed a decision of the Chancery Court finding that corporate directors and officers involved in a sales transaction breached a contract with option holders to fairly value their options (see here for a thorough explanation of the Chancery Court decision, and in particular, the Court’s criticism of the retained financial advisers that provided a valuation analysis).  The Supreme Court decision also included a disproportionately lengthy dissent condemning both the Chancery Court’s findings and its reliance on “social science studies” to reach them.

The underlying action arose out of a sale transaction involving the businesses of Caris Life Sciences, Inc. (“Caris”).  To secure financing for two of its subsidiaries, Caris opted to sell off a third subsidiary in the fall of 2011 to Miraca Holdings, Inc. (“Miraca”).  In an effort to minimize the tax consequences of the sale, Caris structured the transaction as a “spin merge,” whereby Caris transferred ownership of the two subsidiaries to a new subsidiary, which it then spun-off to stockholders.  At that point, owning only the third subsidiary that it wished to sell, Caris simply merged with Miraca, which paid Caris stockholders $725 million in the deal.

More than 97% of Caris’ stock was held by its founder, David Halbert, and an investment fund, JH Whitney VI, L.P.  Halbert and JH Whitney received more than $560 million as part of the Miraca transaction.  Most of the equity in Caris not owned by Halbert or JH Whitney (2.9%) consisted of stock options that were cancelled in connection with the Miraca transaction, with each holder having the right under a 2007 Stock Incentive Plan (the “Plan”) to receive for each covered share the amount by which the fair market value of the share exceeded the option exercise price.  The Plan required the Caris Board to determine the value the option holders would receive.  Caris determined that the spun-off entities had a value of $65 million and that the option holders were entitled to $0.61 per option.

The option holders brought suit, alleging that Caris breached the Plan because, among other things: (i) Caris management, not the Board, determined how much the option holders would receive; and (ii) the per share valuation attributed to the spun-off entities was not a good faith determination of fair market value.  The action was tried in the Chancery Court before Vice Chancellor Laster in December 2014.  The Chancery Court found for plaintiffs, holding that Caris had breached the Plan.  First, the Chancery Court found that the evidence revealed that the Board never made the fair market value determination it was supposed to make.  Rather, that task was delegated to Caris officers under the supervision of Halbert.  Second, the Chancery Court found that the Caris officers themselves had not made a good faith attempt to determine fair market value of the spun-off entities.  They had instead selected figures, in conjunction with Caris’ tax adviser, that would ensure the spin-off and sale would result in zero tax consequences.  The Chancery Court observed that while Caris’ witnesses “testified with conviction” that they believed that the spun-off entities had “very little value in fall 2011,” contemporaneous evidence showed that the directors subjectively believed the spun-off entities had a fair market value of “around $300 million”—almost five times what the valuation turned out to be.  The Chancery Court attributed the discrepancy between the defense witnesses’ trial testimony and evidence from 2011 to “hindsight bias”—the “tendency for people with outcome knowledge to believe falsely that they would have predicted the reported outcome of an event.”  In finding for plaintiffs, the Chancery Court awarded damages of an additional $16.3 million to the option holders for their interest.

Caris appealed.  On June 6, 2016, the Delaware Supreme Court affirmed the lower court’s decision.  In so doing, the Supreme Court gave “deference” to the findings of the Chancery Court, noting that its decision was “supported by the record [and] the product of an orderly and logical deductive reasoning process.”  In particular, the Supreme Court referenced the Chancery Court’s assessment of the Caris witnesses’ credibility and decision “not to credit their unsubstantiated trial testimony,” finding that such decision was not clearly erroneous.

The Supreme Court’s decision was not unanimous, however.  Justice Valihura wrote a lengthy dissent that was sharply critical of the Chancery Court’s decision and supporting analysis.  First, Justice Valihura observed that the Chancery Court improperly made no findings supporting the conclusion that the Caris Board acted in bad faith (and instead found that Board had not “acted” at all).  Justice Valihura stated that the Board had “acted” in the following ways: (i) meeting with legal counsel and hiring an independent adviser to assist directors in determining fair market value; (ii) meeting with its financial adviser and reviewing a valuation analysis; and (iii) adopting a resolution of the Board.  According Justice Valihura, “Boards are permitted to consult with financial advisors when determining a company’s value.”

Second, Justice Valihura stated that the Chancery Court’s rejection of the Caris’ directors’ trial testimony, and attribution of “hindsight bias,” was improper: “In my view, this Court should be skeptical of court rulings predicated upon social science studies, particularly where, as here, such theories impact a trial court’s own post-trial impressions of the testimony offered.”  Indeed, Justice Valihura noted that Vice Chancellor Laster, in an immediate post-trial reaction, stated that “the credibility of the people on the [B]oard” was “very, very strong.”  However, when employing his hindsight bias theory in his decision, Vice Chancellor Laster found that the Caris defense witnesses did not subjectively believe in a low valuation of the spun-off entities.  Justice Valihura concluded that the Chancery Court’s “blanket rejection of thoughtful and consistent testimony by [the Caris] directors . . . does not logically follow from the evidence or from the Court’s own favorable post-trial impressions of the directors’ testimony.”

While the CDX Holdings majority ultimately gave deference to the findings of the Chancery Court, Justice Valihura’s dissent offers an interesting opposing view regarding what constitutes Board “action,” as well as the propriety of using social science studies to determine credibility.