Delaware Court of Chancery Awards Damages in Chevelle Case Based on Unjust Enrichment

By Jay McMillan

An unmarried couple, Kim and Terry, agreed to buy a classic muscle car, have it restored, show it, and eventually sell it for a profit. After a prolonged search, they purchased a 1970 Chevelle. Kim paid for the car, but Terry put the title in his name. Kim also paid storage and restoration costs, for a total of $66,890.47, while Terry contributed a total of only $1,200.00. After Kim caught Terry cheating on her (twice), the couple broke up. Terry claimed full ownership of the Chevelle and tried to sell it. Kim brought suit in the Delaware Court of Chancery to recover the money she spent on the car, storage and restoration, based on several different theories. Jackson v. Nocks, 2018 Del. Ch. LEXIS 130 (Apr. 24, 2018).

First, Kim argued that she and Terry formed a partnership. In Delaware, a partnership is formed through “the association of 2 or more persons (i) to carry on as co-owners a business for profit . . . whether or not the persons intend to form a partnership . . . .” Id. at *13 (quoting 6 Del. C. § 15-202(a)). An essential element of a partnership is that there must be “a common obligation to share losses as well as profits.” Id. at *14. Vice Chancellor Montgomery-Reeves concluded after trial that there was no evidence of such a common obligation. Throughout more than 150 pages of text messages, 31 pages of e-mails, and 22 pages of other documents related specifically to the Chevelle, there was no mention of an agreement to share in potential losses or to split profits. In fact, the couple discussed using the proceeds of a sale of the Chevelle to help fund Terry’s son’s college education. Because there was no common obligation to share profits and losses, the Court rejected Kim’s partnership argument.

Second, Kim argued that she should recover damages for breach of contract. She maintained that she and Terry had a legally enforceable oral agreement “(1) to co-own, restore, show, and eventually sell the Car; (2) split profits 50/50; and (3) split costs associated with the purchase and renovation 50/50.” She sought an order of specific performance of the alleged contract, which would require Terry to repay half the expenses and turn over half the profits from a sale of the Chevelle. In Delaware, “a valid contract exists when (1) the parties intended that the contract would bind them, (2) the terms of the contract are sufficiently definite, and (3) the parties exchange legal consideration.” Id. at *17-18. An intent to be bound requires that the parties to the contract assent to all material terms of the contract. Here, as with the partnership argument, the Court found that there was no agreement to be bound by the alleged terms to share profits and losses. The Court therefore rejected Kim’s contract argument.

Third, Kim argued that if there was no partnership and no contract, she should be entitled to specific performance of a promise under a theory of promissory estoppel. “To state a claim for promissory estoppel, Plaintiff must prove by clear and convincing evidence that (i) a promise was made; (ii) it was the reasonable expectation of the promisor to induce action or forbearance on the part of the promisee; (iii) the promisee reasonably relied on the promise and took action to his detriment; and (iv) such promise is binding because injustice can be avoided only by enforcement of the promise.” Id. at *22. The Court found that the first element was not present because there was no evidence that Terry had made a promise to share costs and profits. Therefore, Kim’s promissory estoppel argument was also rejected.

Fourth and finally, Kim argued that she was entitled to recover under a theory of unjust enrichment. To state a claim for unjust enrichment, a plaintiff must prove (1) that the defendant was enriched, (2) that the plaintiff was impoverished, (3) a relation between the enrichment and impoverishment, (4) the absence of justification, and (5) the absence of a remedy provided by law. Terry argued that the fourth element, the absence of justification, was not present because Kim had given him the Chevelle as a gift; therefore, his enrichment and her impoverishment were justified. This time the Court rejected Terry’s argument. Although Kim had indeed given Terry expensive gifts, including a Nissan Maxima, which he traded for a Lexus, a motorcycle, several watches, clothes, “lavish trips,” and a $200 “weekly allowance,” the evidence showed that the couple had consistently referred to the Chevelle as “ours” and “our girl.” Id. at *23. The Court found that Kim did not have “donative intent” to make a gift of the Chevelle. The Court concluded that “[f]inding for Plaintiff on the basis of unjust enrichment is the equitable remedy here,” and awarded “damages in full,” including all expenditures Kim made on the Chevelle.

Ordinarily, an action solely for money damages cannot be brought in the Court of Chancery because Delaware law provides that the Court of Chancery has jurisdiction over “matters and causes in equity” and does not have jurisdiction to determine matters where a sufficient remedy may be had in any other Delaware state court. 10 Del. C. §§ 341-42. As a court of equity (as opposed to a court of law), the Court of Chancery lacks jurisdiction over the subject matter of a case when there is a sufficient remedy at law—money damages are available in an action at law in the Delaware Superior Court or other Delaware courts.

But based on Jackson v. Nocks, where there is no partnership, no written or oral contract, and no promise made, it is still possible for an aggrieved party to get an award of money damages in the Delaware Court of Chancery based on a theory of unjust enrichment. The Court noted, however, that Terry failed to address the fifth element of an unjust enrichment claim, which is the absence of a remedy at law, and therefore the Court did not discuss it. Unjust enrichment is not in itself an equitable remedy that confers subject matter jurisdiction on the Court of Chancery. Indeed, in Crosse v. BCBSD, Inc., 836 A.2d 492, 496-97 (Del. 2003), the Delaware Supreme Court rejected the argument that an unjust enrichment claim for money damages confers equity jurisdiction on the Court of Chancery without a plea for an equitable remedy. In Jackson v. Nocks, the defendant did not contest the Court of Chancery’s subject matter jurisdiction and the Court did not raise it on its own.

James G. (Jay) McMillan is a partner in the Wilmington, Delaware office of Halloran Farkas + Kittila LLP. He concentrates his practice in complex corporate and commercial matters, with a particular focus on litigation in the Delaware Court of Chancery. For more information on the firm, visit hfk.law.

 

Delaware’s “Safe Harbor” for Self-Interested Transactions Is Not So Safe

By Jay McMillan

Section 144 of the Delaware General Corporation Law provides a “safe harbor” for self-interested transactions between a corporation and one or more of its directors or officers, or between a corporation and another entity in which a director or officer has a material interest. The statute provides that a transaction is not “void or voidable” solely because of such a conflict. Similar provisions sometimes appear in partnership agreements or operating agreements of limited liability companies. However, those safe harbor provisions provide little protection from claims for breach of fiduciary duty against officers and directors.

The Section 144 safe harbor applies if (1) the conflicted transaction is approved by a majority of fully informed disinterested directors, or (2) it is approved in good faith by a vote of fully informed stockholders, or (3) it is “fair as to the corporation” at the time it is approved by the board of directors, a committee of the board, or the stockholders. In Cumming v. Edens, C.A. No. 13007-VCS, mem. op. at 54-59 (Del. Ch. Feb. 20, 2018), the director defendants argued that compliance with Section 144 triggered review of a conflicted transaction under the deferential business judgment standard. They further argued that because Section 144 refers only to “disinterested” directors, the Court should not consider whether the directors approving the transaction were also independent of any interested directors. The defendants relied on Benihana of Tokyo, Inc. v. Benihana, Inc., 906 A.2d 114 (Del. 2006) (“Benihana II”), in which the Delaware Supreme Court stated that under Section 144(a)(1) “[a]fter approval by disinterested directors, courts review the interested transaction under the business judgment rule . . . .”

In Cumming, Vice Chancellor Joseph R. Slights III found that despite Benihana II, “compliance with Section 144(a)(1) does not necessarily invoke business judgment review of an interested transaction” and that common law principles still apply when determining the standard of review. The Court referred to the opinion of Vice Chancellor Parsons in Benihana of Tokyo, Inc. v. Benihana, Inc., 891 A.2d 150, 185 (Del. Ch. 2005) (“Benihana I”), aff’d, 906 A.2d 114 (Del. 2006), which was affirmed in Benihana II. In Benihana I the Court stated that compliance with Section 144 does not “always” trigger business judgment review, and that “equitable common law rules requiring the application of the entire fairness standard on grounds other than a director’s interest still apply.”

The Court in Cumming noted that before Section 144 was enacted in 1967 “a corporation’s stockholders had the right to nullify an interested transaction” and that Section 144 was enacted to prevent that “potentially harsh result.” Under Section 144, stockholders cannot void a transaction “solely” because of the presence of director self-interest. Cumming makes clear, however, that compliance with Section 144 does not provide a safe harbor against claims for breach of fiduciary duty.

An appeal of the Cumming decision based on the Delaware Supreme Court’s language in Benihana II is unlikely to succeed. The Court in Cumming also noted that in an article by Delaware Supreme Court Chief Justice Leo E. Strine, Jr. et al., the authors stated, “The question of whether section 144 was intended to create a safe harbor from equitable review… is controversial…. To date, the Delaware courts have generally read the statute more narrowly, while drawing on it in crafting rulings in equity.” On appeal, the Delaware Supreme Court is likely to read Section 144 “narrowly.”

The Court in Cumming also disagreed with the view that compliance with Section 144 shifts the burden of proving the fairness of a conflicted transaction to the plaintiff. In the respected treatise Folk on the Delaware General Corporation Law, the authors (attorneys in the Delaware office of Skadden Arps) state “[c]ompliance with Section 144 merely shifts the burden to the plaintiffs to demonstrate that the transaction was unfair.” The Court stated “[w]hile I cannot say that I share that view of our law, I need not weigh in on that issue at this stage in the proceedings.”

Having rejected the Section 144 defense, the Court in Cumming denied the defendants’ motion to dismiss for failure to state a claim, finding that the complaint adequately alleged “that the Board acted out of self-interest or with allegiance to interests other than the stockholders’.” Based on that finding, the Court applied the entire fairness standard of review and concluded that, based on the allegations of the complaint, the transaction was not fair to the corporation’s stockholders because it was not the product of “fair dealing” and did not reflect a “fair price.”

In short, a transaction that complies with Section 144 based on an informed vote of disinterested directors or stockholders will not necessarily be subject to business judgment review and will not necessarily pass entire fairness review. The Section 144 “safe harbor” is not safe from claims for breach of fiduciary duty.

Also of interest in the Cumming opinion is that the Court found that two directors were not independent based on ties to an interested director through (1) common ownership of a unique asset and (2) common board membership. In the first case, the director had been invited by the interested director, Edens, to invest with him in the Milwaukee Bucks NBA basketball franchise, an opportunity available to only 25 investors, and had assisted Edens in an effort to build a new arena for the team. Although the joint investment did not require the cooperative planning that the ownership of a private plane did in Sandys v. Pincus, the Court found that the “dynamics” of the relationship were not “any less revealing of a unique, close personal relationship.”

In the second case the director in question also served with Edens on the board of another company, both of which were managed by Fortress, a company of which Edens was a principal. Fortress was the parent company of the counter-party to the challenged transaction. The director was placed on both boards by Fortress and derived 60% of his publicly reported income from Fortress-managed companies. He also listed Fortress as his forwarding address on public filings for unrelated investments. The Court concluded that the director lacked independence because of his “material ties” to Edens and Fortress.

James G. (Jay) McMillan is a partner in the Wilmington, Delaware office of Halloran Farkas + Kittila LLP. He concentrates his practice in complex corporate and commercial matters, with a particular focus on litigation in the Delaware Court of Chancery. For more information on the firm, visit hfk.law.

Delaware Supreme Court Affirms Dismissal of Wal-Mart Case

By Jay McMillan

In California State Teachers’ Retirement System v. Alvarez, 2018 Del. LEXIS 41 (Del. Jan. 25, 2018), the Delaware Supreme Court affirmed the Court of Chancery’s dismissal of a derivative suit against the board of directors of Wal-Mart Stores, Inc., finding that the claims were precluded because a similar suit in an Arkansas federal court had been dismissed for the stockholder plaintiffs’ failure to make a demand for action on the board, or to plead that such a demand would be futile. The Court found that the Arkansas plaintiffs’ representation of the corporation’s stockholders was not “grossly deficient” despite their failure to make a demand for inspection of corporate books and records under Section 220 of the Delaware General Corporation Law. The Court also rejected Chancellor Andre G. Bouchard’s recommendation that it adopt a more plaintiff-friendly standard.

The Delaware and Arkansas suits both asserted claims for breach of fiduciary duty against Wal-Mart’s directors for failure to adequately oversee the company’s Mexican unit, Wal-Mart de Mexico (WalMex), whose executives allegedly engaged in a bribery scheme and cover-up. Following an April 2012 report in the New York Times, eight derivative complaints were filed in the United States District Court for the Western District of Arkansas, and seven more were filed in the Delaware Court of Chancery. The Arkansas court initially stayed its proceedings pending the Delaware action. At the urging of then-Chancellor Leo Strine, the Delaware plaintiffs sought Wal-Mart’s books and records under Section 220. However, the “unusually contentious” Section 220 action dragged on for three years.

Meanwhile, in 2013, the Arkansas court’s stay was lifted and, on March 31, 2015, the Arkansas court granted the director defendants’ motion to dismiss with prejudice for the plaintiffs’ failure to make demand or plead demand futility as required by Rule 23.1 of the Federal Rules of Civil Procedure. One month later, on May 1, 2015, the Delaware plaintiffs amended their complaint based on what they had learned from Wal-Mart’s books and records. The director defendants moved to dismiss the amended complaint based on res judicata, or issue preclusion, arguing that the Delaware plaintiffs were precluded by the Arkansas dismissal from pleading that demand was excused as futile.

Chancellor Bouchard granted the motion to dismiss based on res judicata. The stockholder plaintiffs appealed to the Delaware Supreme Court, arguing, among other things, that they were denied their federal right of due process. The Delaware Supreme Court affirmed the dismissal, finding that the issues were the same in both actions and that the plaintiffs in the two actions were “in privity,” or had identical interests, because, under applicable Arkansas law and federal law, the real party in interest in both cases was the corporation.

Chancellor Bouchard’s recommendation that the Delaware Supreme Court should establish a more plaintiff-friendly standard was rejected. In a supplemental opinion issued on remand, Chancellor Bouchard suggested that res judicata should not apply where an action in another jurisdiction was dismissed for failure to make demand. The Chancellor recommended that the Delaware Supreme Court adopt a rule proposed by Vice Chancellor J. Travis Laster in In re EZCORP Inc. Consulting Agreement Derivative Litigation, 130 A.3d 934 (Del. Ch. 2016), which would allow other representative plaintiffs to assert derivative claims after an action was dismissed under Rule 23.1. The Chancellor suggested that such a rule would “better safeguard the due process rights of stockholder plaintiffs and should go a long way to addressing fast-filer problems currently inherent in multi-forum derivative litigation.”

The Delaware Supreme Court disagreed, finding that all three federal circuit courts of appeal that addressed the issue held that stockholder plaintiffs’ due process rights were protected “when their interests were aligned with and were adequately represented by the prior plaintiffs,” and that “most other cases” granted preclusive effect to prior Rule 23.1 dismissals.

The Delaware Supreme Court found that the Arkansas plaintiffs and the Delaware plaintiffs had an identity of interests, that they were both aware that a judgment in one case could have a preclusive effect on the other case, and that the Arkansas stockholder plaintiffs adequately represented the Delaware stockholder plaintiffs. As to adequacy of representation, the Delaware Supreme Court found that “(i) the quality of their representation was not grossly deficient, and (ii) their economic interests were not antagonistic to other stockholders.” The Court found that the Arkansas plaintiffs decided not to make a Section 220 demand – as urged by then-Chancellor Strine – because they thought that documents in the public domain cited in the New York Times article were sufficient to plead demand futility. Although that turned out to be a “tactical error,” the decision not to make a Section 220 demand “in this instance does not rise to the level of constitutional inadequacy.” (Emphasis in original).

The Delaware Supreme Court thus left open the possibility that failure to make a Section 220 demand could in another instance make a plaintiff an inadequate representative, which would allow a subsequent plaintiff to proceed without preclusion. The Court agreed, however, with the Court of Chancery’s conclusion that “it does not follow that plaintiffs are necessarily inadequate representatives because their counsel chose not to follow a recommended strategy in a different action, even one suggested by a preeminent corporate jurist, particularly when they are litigating in a different jurisdiction before a different judiciary.” The Arkansas plaintiffs were not inadequate representatives merely because they failed to make a Section 220 demand or because they subsequently failed to adequately plead demand futility.

James G. (Jay) McMillan is a partner in the Wilmington, Delaware office of Halloran Farkas + Kittila LLP. He concentrates his practice in complex corporate and commercial matters, with a particular focus on litigation in the Delaware Court of Chancery. For more information on the firm, visit hfk.law.

Director Compensation Amounts Must Be Approved by Stockholders to Avoid Entire-Fairness Review: Delaware Supreme Court Rejects “Meaningful Limits” Standard

By Jay McMillan

Although the Delaware General Corporation Law allows corporate boards of directors to set their own compensation (see 8 Del. C. § 141(h)), Delaware courts have found that, because those decisions are self-interested, they are subject to the stringent entire fairness standard of judicial review when challenged by stockholders. See Telxon Corp. v. Meyerson, 802 A.2d 257, 262 (Del. 2002). However, it has long been established that director self-compensation decisions can be “ratified” by an informed, uncoerced vote of disinterested stockholders, in which case they are reviewed under the deferential business judgment standard. See Kerbs v. Cal. E. Airways, Inc., 90 A.2d 652 (Del. 1952); Gottlieb v. Heyden Chem. Corp., 90 A.2d 660 (Del. 1960). Following recent opinions by the Delaware Court of Chancery, directors have been able to assert a ratification defense to claims of unfair compensation not only where the amounts were specifically approved by a stockholder vote, but also where the amounts were awarded under a stockholder-approved plan that set “meaningful limits” on director compensation. See Seinfeld v. Slager, 2012 Del. Ch. LEXIS 139, at *41 (Del. Ch. June 29, 2012).

In In re Investors Bancorp, Inc. Stockholder Litigation, 2017 Del. LEXIS 517, at *25 (Del. Dec. 13, 2017) (revised Dec. 19, 2017), the Delaware Supreme Court overruled the “meaningful limits” standard and reversed the Court of Chancery’s ruling in favor of the corporation’s directors, holding that where directors are given discretion to award their own compensation under a stockholder-approved plan, they must exercise that discretion in keeping with their fiduciary duties. Where a stockholder complaint adequately alleges a breach of fiduciary duty in the exercise of discretion after stockholder ratification of a plan, the complaint will survive a motion to dismiss.

The corporation, Investors Bancorp, Inc., was a publicly held bank holding company. The complaint asserted derivative claims against the corporation’s ten non-employee directors and two executive directors. It alleged that the non-employee directors were awarded an average of $2,100,000 each in stock options and restricted stock in 2015, compared with total compensation of between $97,200 and $207,005 each in 2014, and that their compensation “eclips[ed] director pay at every Wall Street firm.” The 2015 equity awards were made under an incentive plan that reserved approximately 9.3 million shares specifically for outside directors. In 2014, the company had sold approximately 220 million shares to the public at $10.00 per share. The plan provided that all of the reserved shares could be granted to the non-employee directors in any one year. The total value of the 2015 awards for all 12 non-employee and executive directors was approximately $51.5 million.

The Court of Chancery found that the plan contained “meaningful limits” because it contained limits specific to the non-employee directors. 2017 Del. Ch. LEXIS 53, at *23 (Del. Ch. Apr. 5, 2017). While acknowledging that the awards were “quite large,” the Court of Chancery rejected the plaintiffs’ argument that the Court should determine when limits set by a compensation plan are “meaningful,” stating that such a test “would propel the court into a position where it was second-guessing the informed decision of stockholders to approve compensation for the company’s directors and officers.” Id. at *25 n.33. Where fully informed stockholders ratify director compensation, the complaint will be dismissed unless the plaintiffs can invoke “the vestigial waste exception [which] has long had little real-world relevance, because it has been understood that stockholders would be unlikely to approve a transaction that is wasteful.” Id. (quoting Singh v. Attenborough, 137 A.3d 151, 151-52 (Del. 2016)).

The Delaware Supreme Court disagreed with the Court of Chancery, finding it “reasonably conceivable” based on the allegations of the complaint that the directors breached their fiduciary duties. The plaintiffs alleged that the awards were excessive compared to those made at peer companies and that, although the proxy statement suggested that the awards were to be made prospectively, the board made the awards based on past performance that had already been compensated. Based on those allegations, the Delaware Supreme Court found that the complaint stated a claim “that the directors breached their fiduciary duties in making unfair and excessive discretionary awards to themselves” and concluded “[b]ecause the stockholders did not ratify the specific awards the directors made under the [equity compensation plan], the directors must demonstrate the fairness of the awards to the Company.”

After Investors Bancorp, it is not sufficient that a stockholder-ratified plan sets “meaningful limits” or that it contains limits specific to outside directors. For directors to avoid entire-fairness review, stockholders must either ratify the “specific awards” or the awards must be made under “self-executing plans, meaning plans that make awards over time based on fixed criteria, with the specific amounts and terms approved by stockholders.” To avoid entire fairness review, either the specific amounts must be approved or the plan must leave no discretion to the directors in making awards.

Comment from my partner Mike Halloran:

       “It should not be suggested that stockholder approval or ratification of compensation paid to directors is either commonplace or necessary, because it is not. I recommend that, as directors cannot now rely on general wording to describe director compensation in compensation plans, they should be careful to consider appropriate information, such as compensation paid to directors of comparable companies, when approving compensation for themselves, to avoid the risk of having it reversed in an entire fairness trial.”

James G. (Jay) McMillan is a partner in the Wilmington, Delaware office of Halloran Farkas + Kittila LLP. He concentrates his practice in complex corporate and commercial matters, with a particular focus on litigation in the Delaware Court of Chancery. For more information on the firm, visit hfk.law.

Stock Reclassification that Perpetuated Majority Stockholder’s Control Approved by Delaware Court of Chancery

By Jay McMillan

Founders and majority stockholders who wish to raise capital by issuing additional stock may want to do so without relinquishing majority voting power, even after they no longer hold a majority of the corporation’s shares. They can maintain control by reclassifying the corporation’s stock so that that the controller’s stock has superior voting rights, often 10 times that of the common shares. Earlier this year, Facebook’s Mark Zuckerberg, who already held super-voting shares, proposed a plan under which newly issued shares would have no voting rights. Although similar plans had been successfully implemented by Alphabet (Google’s parent) and Snap Inc. (formerly Snapchat, Inc.), the Facebook plan was withdrawn in the face of litigation brought by the company’s stockholders in the Delaware Court of Chancery.

Another company that successfully reclassified its shares is NRG Yield, Inc., a Delaware corporation that owns a portfolio of income-producing assets in the energy generation and infrastructure fields. Its majority stockholder, NRG Energy, Inc., initially held 65% of the company’s stock, but the issuance of additional equity reduced its control to about 55%, and further equity sales would have eliminated NRG Energy’s majority control in a relatively short period. In May 2015, NRG Yield effected a stock reclassification under which new Class C and D shares were issued with only one one-hundreth of the voting power of the outstanding Class A and B shares. Because any new equity holders would have much lower voting power, NRG Energy would maintain its control of the vote much longer. The reclassification was negotiated and approved by a committee of independent directors and was conditioned on approval by a majority of stockholders unaffiliated with the controller.

In September 2016, an NRG Yield stockholder filed a class-action complaint in the Delaware Court of Chancery alleging that the company’s directors and NRG Energy as its controlling stockholder breached their fiduciary duties by approving the reclassification, based on the theory that NRG Energy received a benefit not shared with other stockholders by “perpetuating” its control of NRG Yield. In IRA Trust fbo Bobbie Ahmed v. Crane, 2017 Del. Ch. LEXIS 843 (Del. Ch. Dec. 11, 2017), Chancellor Andre G. Bouchard found that although NRG Energy did receive a unique benefit, which would make the transaction subject to the stringent entire fairness standard of review, the approval of a committee of independent directors and the fully informed, uncoerced vote of a majority of the minority stockholders made the transaction subject to the defendant-friendly business judgment standard of review, and required dismissal of the complaint.

The Court applied the “MFW” standard established by the Delaware Supreme Court in Kahn v. M&F Worldwide Corp., 88 A.3d 635 (Del. 2014). Under MFW the business judgment standard applies to a conflicted transaction if six elements are present:

(i) the controller conditions the procession of the transaction on the approval of both a Special Committee and a majority of the minority stockholders; (ii) the Special Committee is independent; (iii) the Special Committee is empowered to freely select its own advisors and to say no definitively; (iv) the Special Committee meets its duty of care in negotiating a fair price; (v) the vote of the minority is informed; and (vi) there is no coercion of the minority.

88 A.3d at 645. MFW involved a merger transaction. The Court in Crane rejected the plaintiff’s argument that the MFW standard should apply only to mergers, stating “I see no principled reason why that rationale would not apply equally to other conflicted controller transactions.”

Crane represents a step in the “evolution” of the MFW doctrine, making it clear that the standard is not limited to mergers, but also provides a roadmap for other conflicted transactions with controlling stockholders. Specifically, in the case of stock reclassifications that prolong or perpetuate a majority stockholder’s control, a Delaware corporation can ensure favorable review if the transaction is conditioned from the outset on the approval of a special committee of independent directors with a mandate that allows it to freely select its own legal and financial advisors, to meet its duty of care in negotiating with the majority stockholder, and to definitively say no, and on the informed, uncoerced vote of a majority of the minority stockholders.

James G. (Jay) McMillan is a partner in the Wilmington, Delaware office of Halloran Farkas + Kittila LLP. He concentrates his practice in complex corporate and commercial matters, with a particular focus on litigation in the Delaware Court of Chancery. For more information on the firm, visit hfk.law.

Delaware Court of Chancery Slams Plaintiffs’ Firm for Using “Ostensible” Stockholder Plaintiff in Books and Records Action

By Jay McMillan

The Delaware Court of Chancery has held, apparently for the first time, that the requisite “proper purpose” in a books and records action must be the stockholder’s own purpose and not one devised by the stockholder’s lawyers. Based on the Court’s ruling in Wilkinson v. A. Schulman, Inc., C.A. No. 2017-0138-JTL, 2017 Del. Ch. LEXIS 798 (Del. Ch. Nov. 13, 2017), stockholder plaintiffs in books and records actions will be required to have “substantive involvement” in the litigation – a requirement that does not exist in stockholder class-action and derivative cases.

The Delaware Supreme Court has urged stockholder plaintiffs to use the “tools at hand,” in particular the right to inspect and copy corporate books and records under Section 220 of the Delaware General Corporation Law, to investigate potential claims before bringing plenary actions challenging corporate transactions. See Rales v. Blasband, 634 A.2d 927, 934 n.10 (Del. 1993); Grimes v. Donald, 673 A.2d 1207, 1216 & n.11 (Del. 1996). However, where a stockholder in a Delaware corporation seeks inspection of the corporation’s books and records, other than its stock ledger or list of stockholders, Section 220 requires the stockholder to establish that the inspection sought is “for a proper purpose,” defined as “a purpose reasonably related to such person’s interest as a stockholder.” In Wilkinson, the Delaware Court of Chancery has found that the required proper purpose must be the stockholder’s own purpose and not one devised by the stockholder’s counsel.

Based on a stockholder plaintiff’s admission that his stated purpose for inspection was his counsel’s invention and not his own, the Court granted judgment in favor of the corporate defendant and against the stockholder following a bench trial. In Wilkinson, Vice Chancellor J. Travis Laster rejected the plaintiff’s books and records demand based on his finding that the plaintiff’s stated purpose for inspection was not his true purpose.

The plaintiff, represented by the New York firm Levi & Korsinsky, LLP (“L&K”), sought inspection of the books and records of plastics maker A. Schulman, Inc. for the stated purpose of investigating a decision by the corporation’s board of directors to accelerate the vesting of shares of restricted stock, valued at more than $3.9 million, for the corporation’s president and chief executive officer upon his retirement at the end of 2014. However, the plaintiff testified that he contacted L&K because he was concerned with the corporation’s November 2016 announcement of a loss of $365 million following the acquisition of another plastics company. The plaintiff testified that he was not aware of any impropriety concerning the 2014 compensation award.

The Court found that “Wilkinson simply lent his name to a lawyer-driven effort by entrepreneurial plaintiffs’ counsel” and that he “did not take any steps to confirm the accuracy of the allegations in the complaint,” did not read the corporation’s answer to the complaint, and did not participate in drafting answers to interrogatories, but rather verified the complaint and interrogatory answers in reliance on his counsel.

The Court may have been influenced by the fact that Wilkinson was a serial plaintiff. The Court noted that Wilkinson had been a plaintiff in at least seven L&K lawsuits, “most of which challenged mergers,” that he “did not do anything to verify the factual allegations in those lawsuits, other than to read the complaints that L&K drafted,” that he “agreed to serve as a plaintiff reflexively after seeing the press releases L&K issued announcing investigations into the transactions,” and that he participated “because he wanted more money for his shares, regardless of whether the deal price was fair,” that he “never received a dime of additional consideration,” and that “most, if not all, of the cases settled for supplemental disclosures.” The Court did not, however, suggest that Wilkinson had been found to be an inadequate stockholder representative in any of those seven cases.

The Court emphasized that it is advisable for stockholders seeking inspection of corporate books and records to retain experienced counsel, but stated that “retaining counsel to carry out the stockholder’s wishes is fundamentally different than having an entrepreneurial law firm initiate the process, draft a demand to investigate different issues than what motivated the stockholder to respond to the law firm’s solicitation, and then pursue the inspection and litigate with only minor and non-substantive involvement from the ostensible stockholder principal.”

The Court’s decision in Wilkinson reflects some of the obstacles that may confront a stockholder bringing a books and records action. The opinion suggests that stockholder plaintiffs in books and records actions must act on their own initiative with a proper purpose in mind and that they must have substantive involvement in the litigation. In a plenary class or derivative action, there is no “proper purpose” requirement, and the only statutory requirement under Delaware law is that the plaintiff in a derivative action must have held shares at the time of the challenged transaction. See 8 Del. C. § 327. The Court has never required class-action or derivative plaintiffs to be self-motivated or have substantive involvement in litigation. Thus, based on Section 220’s “proper purpose” requirement, the Court of Chancery would appear to require more from a books and records plaintiff seeking to use the “tools at hand” to investigate a transaction than it would require of the same plaintiff bringing a plenary action challenging the same transaction without first bringing a Section 220 action.

James G. (Jay) McMillan is a partner in the Wilmington, Delaware office of Halloran Farkas + Kittila LLP. He concentrates his practice in complex corporate and commercial matters, with a particular focus on litigation in the Delaware Court of Chancery. For more information on the firm, visit hfk.law.

Delaware Supreme Court Sends Plaintiffs to Bring Suit in Bulgaria, Establishes Intermediate Standard for First-Filed Cases

By Jay McMillan

Although Delaware is the preferred jurisdiction for deciding business disputes, it sometimes happens that a defendant would prefer to litigate elsewhere. When that happens the defendant may move to dismiss the action based on forum non conveniens, that is, because the forum is not convenient to the defendant. The decisive factor in such cases is whether there is a prior-filed action pending in another jurisdiction. Delaware courts typically rule in favor of the first-filed action. Where the Delaware action is first-filed, to prevail on a motion to dismiss, the defendant must show that it would suffer “overwhelming hardship” from being forced to litigate in Delaware. Where a prior-filed action is pending in another jurisdiction, a Delaware court will grant the motion to dismiss if the other action involves the same parties and the same issues and was brought in a court capable of doing prompt and complete justice. Either way, the prior-filed action is favored.

A less common scenario arises when a prior-filed action has been brought in another jurisdiction but is no longer pending. In a recent Delaware Supreme Court case, Gramercy Emerging Markets Fund v. Allied Irish Banks, p.l.c., 2017 Del. LEXIS 452 (Del. Oct. 27, 2017), the plaintiffs, a Cayman Islands company and two Delaware subsidiaries, had first brought suit in Illinois against the defendants, a bank organized under Delaware law with offices in Illinois and Bulgaria, and an Irish bank based in Dublin. The claims were brought under Bulgarian law. The Illinois court dismissed the complaint based on forum non conveniens. The plaintiffs then filed suit in the Delaware Court of Chancery, where Vice Chancellor Sam Glasscock III granted the defendants’ motions to dismiss on the same grounds.

The Delaware Supreme Court affirmed, finding that the plaintiffs’ claims “involve important and unsettled issues of Bulgarian securities law arising out of an investment in a Bulgarian bank” and that the plaintiffs knew from the start that they were investing in a Bulgarian bank governed by Bulgarian law.

Forum non conveniens standards: Cryo-Maid and McWane

Where the Delaware case is first-filed, Delaware courts apply a plaintiff-friendly standard based on General Foods Corp. v. Cryo-Maid, Inc., 198 A.2d 681 (Del. 1964) which requires a defendant to show that it would suffer “overwhelming hardship” from being forced to litigate in Delaware. This is because Delaware courts are reluctant “to lightly disturb a plaintiff’s first choice of fora.” Under Cryo-Maid, the court considers five factors: “(1) [t]he relative ease of access to proof; (2) the availability of compulsory process for witnesses; (3) the possibility of the view of the premises, if appropriate; . . . (4) all other practical problems that would make the trial of the case easy, expeditious and inexpensive;” and (5) “whether or not the controversy is dependent upon the application of Delaware law which the courts of this State more properly should decide than those of another jurisdiction.” The court also considers a sixth factor, whether or not there is a similar action pending in another jurisdiction.

Where the Delaware case is not the first-filed case and the earlier case is pending in another jurisdiction, the analysis favors the defendant (who is typically the plaintiff in the other, first-filed case) and the court applies a defendant-friendly standard based on McWane Cast Iron Pipe Corp. v. McDowell-Wellman Engineering Co., 263 A.2d 281 (Del. 1970). Under McWane, dismissal is within the court’s discretion and is strongly favored where: “(1) [there is] a prior action pending elsewhere; (2) in a court capable of doing prompt and complete justice; (3) involving the same parties and the same issues.”

In another, more recent case, Lisa, S.A. v. Mayorga, 993 A.2d 1042 (Del. 2010), three actions that the plaintiff had filed in Florida had been dismissed, one of them on the merits with prejudice, so there was no prior-filed case pending elsewhere. The Court of Chancery applied the Cryo-Maid factors and found that litigating in the alternative forum (Guatemala) would cause the defendant “overwhelming hardship.” The Delaware Supreme Court affirmed, but did so under McWane, finding that the fact that the Florida action was no longer pending did not change the outcome, and that McWane should apply because the plaintiff-friendly standard of Cryo-Maid “would ignore the binding effect of the Florida adjudication, and create the possibility of inconsistent and conflicting rulings.” Allowing the plaintiff to proceed in Delaware after dismissal on the merits in Florida would be “precisely the outcome McWane’s doctrine of comity seeks to prevent.”

In Gramercy, however, the prior-filed action was dismissed not on the merits, but on procedural grounds, without prejudice. Therefore, the Court of Chancery treated the Delaware action as first-filed and applied the plaintiff-friendly Cryo-Maid standard. However, the Court found in favor of the defendants, granting their motions to dismiss without finding that they would suffer overwhelming hardship. On appeal, the plaintiff argued that the Court of Chancery should have applied the overwhelming hardship standard. The Delaware Supreme Court rejected that argument and affirmed the Court of Chancery’s ruling in favor of the defendants. In addition, the Supreme Court clarified “the spectrum of standards under which motions for forum non conveniens are considered in Delaware.” The Court established an “intermediate” standard, concluding that “when a case is later-filed and its predecessors are no longer pending, the analysis is not tilted in favor of the plaintiff or the defendant. In that situation, Delaware trial judges exercise their discretion and award dismissal when the Cryo-Maid factors weigh in favor of that outcome.”

The Delaware Supreme Court found that its earlier ruling in Lisa was “case-specific.” In Lisa, the Court of Chancery ruled in favor of the defendant even under the plaintiff-friendly Cryo-Maid standard. Had Lisa been decided by balancing the Cryo-Maid factors under the neutral standard prescribed by Gramercy, without the overwhelming hardship “overlay,” rather than under the defendant-friendly McWane standard used by the Delaware Supreme Court in that case, the outcome would have been the same.

James G. (Jay) McMillan is a partner in the Wilmington, Delaware office of Halloran Farkas + Kittila LLP. He concentrates his practice in complex corporate and commercial matters, with a particular focus on litigation in the Delaware Court of Chancery. For more information on the firm, visit hfk.law.

Plaintiff who Alleged that Corporation “Illegally Committed” Patients to Mental-Health Facilities Can’t Cherry-Pick Documents

By Jay McMillan

In drafting a complaint, an attorney might rely on a document “in isolation, not in bad faith but perhaps over-zealously in the belief that the document reveals more than it does.” Amalgamated Bank v. Yahoo! Inc., 132 A.3d 752, 799 (Del. Ch. 2016). Ordinarily, a defendant responding to such a complaint in a Delaware state court could be frustrated by the rule that blocks the defendant from introducing other documents in the same context unless they are specifically incorporated by reference in the complaint. But that rule does not always apply.

In several recent cases involving stockholder demands for inspection of corporate books and records, the Delaware Court of Chancery has approved an “incorporation condition” providing that all documents produced by the corporation in response to such a demand are incorporated into any subsequent derivative complaint filed by the stockholder against the corporation’s directors on behalf of the corporation. Ordinarily, a defendant may only move to dismiss a complaint based on the insufficiency of the complaint itself and the documents incorporated by reference in the complaint. In other words, at the pleading stage a defendant may not refute the plaintiff’s documents with other documents of its own. However, where an incorporation condition applies, the defendant may use any of the documents it produced to the stockholder plaintiff in response to a books-and-records demand. A recent case, City of Cambridge Retirement System v. Universal Health Services, Inc., C.A. No. 2017-0322-SG (Oct. 12, 2017), solidifies the use of incorporation conditions in books-and-records cases.

In that case, the corporation, UHS, agreed to produce documents in response to a stockholder demand only if the stockholder entered into a confidentiality agreement with an incorporation condition. The stockholder refused and brought a books-and-records action in the Court of Chancery under Section 220 of the Delaware General Corporation Law, seeking production of the documents free of the incorporation condition.

Although the allegations against UHS were sensational, Vice Chancellor Sam Glasscock III found in UHS’s favor on the narrow issue of the incorporation provision. The plaintiff alleged that UHS illegally committed patients to behavioral health facilities by luring them in with “advertisements for free wellness examinations … [and] trick[ing] patients into implying they harbored suicidal thoughts,” keeping them in the facilities “until their insurance benefits ran out.” The Court in a footnote pointed out that UHS “stoutly denied” the allegations, but “If true, in addition to being morally despicable behavior by the individuals responsible, this would represent the worst abuse of a Delaware corporate franchise of which I am aware.”

The plaintiff argued that incorporation provisions are “pernicious” because they allow companies to “manipulate” their document productions “without any punishment for failing to produce [harmful] documents.” Although the Court pointed out that the same argument could be made about a corporation’s ability to manipulate the record available to a plaintiff through discovery on a motion for summary judgment, the plaintiff argued that a stockholder making a Section 220 demand “has substantially less ability to test the sufficiency of production, compared with a litigant receiving discovery.” The Court rejected that argument, concluding that “the benefits of allowing the court to eliminate complaints involving misleading citations to a limited subset of records” outweighed “the risk of potential malfeasance” by producing defendants.

The Court stressed that the standard on a motion to dismiss in Delaware “remains plaintiff-friendly” – a complaint survives unless the plaintiff could not prevail based on any “reasonably conceivable” set of facts inferable from the complaint. The Court expressed confidence in its ability, “through proper application of that standard [to] eliminate much of the risk of gamesmanship and improper dismissal.”

The Court found that the plaintiff in UHS had failed to distinguish the previous cases in which the Court had approved incorporation conditions. Those cases, along with UHS, make incorporation conditions virtually the norm in books and records cases. After UHS, Stockholders making books-and-records demands and corporations confronted with them should both anticipate that any production will be subject to a confidentiality agreement that includes an incorporation condition.

James G. (Jay) McMillan is a partner in the Wilmington, Delaware office of Halloran Farkas + Kittila LLP. He concentrates his practice in complex corporate and commercial matters, with a particular focus on litigation in the Delaware Court of Chancery. For more information about the firm, visit hfk.law.

Directors May Not Knowingly Allow a Corporation to Violate the Law

By Jay McMillan

The Delaware Court of Chancery has found that corporate directors breach their duty of good faith if they knowingly allow their corporation to violate positive law, for profit or otherwise.[1] Directors of Delaware corporations can be held personally liable for fines and other damages resulting from known violations of law. In Kandell v. Nviv, Civil Action No. 11812-VCG (Sept. 29, 2017), the stockholder plaintiff brought a derivative action against the directors of FXCM, Inc., a “foreign exchange broker” engaged in the business of buying and selling foreign currencies on customers’ orders. Industry practice was that customers’ trades were highly leveraged, but FXCM distinguished itself by promising clients that it would not attempt to collect on their losses beyond the relatively small amounts they invested. That policy at first led to significantly higher revenues.

The Corporation’s Violations of Law

However, rules promulgated by the United States Commodity Futures Trading Commission (CFTC) in connection with the Dodd-Frank Act of 2010 prohibit foreign exchange traders such as FXCM from representing that they will limit their clients’ trading losses. According to the plaintiff, FXCM’s board knowingly allowed the corporation to violate 17 C.F.R. (Code of Federal Regulations) § 5.16 (Regulation 5.16). The directors’ knowledge was evidenced by the company’s public filings, which disclosed a “risk” that Regulation 5.16 forbade making guarantees against loss to retail foreign exchange customers. The directors were thus aware of Regulation 5.16 and of the company’s advertised policy of not pursuing customer losses beyond the investment amount.

The policy eventually led to catastrophic losses for FXCM. On January 15, 2015, the Swiss National Bank announced that it would allow the Swiss franc to “float freely” against the euro, leading to a “Flash Crash.” In the 45 minutes following the announcement, FXCM customers “locked in” losses of $276 million, which FXCM was unable to collect because of its liberal policy regarding customer losses.

The Complaint and the Court’s Ruling

The derivative complaint, initially filed in December 2015, sought damages from the directors on behalf of the corporation for losses incurred in the Flash Crash. The defendants moved to dismiss the complaint, arguing that while they knew of Regulation 5.16 and of the corporation’s policy, they did not know that the policy violated Regulation 5.16.

Denying the motions to dismiss, Vice Chancellor Glasscock looked to the text of Regulation 5.16, which provides that no retail foreign exchange dealer may “guarantee” a customer against loss or “Limit the loss of such person.” The Court found that “the Regulation itself, on my reading, clearly prohibits touting loss limitations to clients, and I find that the Company did precisely that.” The Court stated that “my reading of Regulation 5.16 is sufficient at the pleadings stage to infer scienter” on the part of the board. Because the Regulation clearly prohibited the corporation’s conduct, the Court inferred that the directors were aware that the corporation was in violation of Regulation 5.16. The Court emphasized that the case presented “a highly unusual set of facts” in which a corporation’s business model relied on “a clear violation of a federal regulation” of which it could be inferred that the board had knowledge.

The Court noted that this case did not involve a typical Caremark claim because it did not involve “a director’s bad-faith failure to exercise oversight over the company” to ensure that violations of law did not occur, but rather involved violations of law that were actually known to the directors. In Caremark, the Court of Chancery approved a settlement because it found that the record did not “tend to show knowing or intentional violation of law” by the director defendants. In re Caremark International, Inc. Derivative Litigation, 698 A.2d 959, 961 (Del. Ch. 1996). Neither Caremark nor FXCM involved a mere breach of the duty of care that could be exculpated by a corporate charter provision under Section 102(b)(7) of the Delaware General Corporation Law. The statute expressly excludes exculpation for “acts or omissions not in good faith or which involve intentional misconduct or a knowing violation of law.” 8 Del. C. § 102(b)(7).[2]

Practice Pointers

Attorneys advising boards of directors should stress that corporate directors may not tolerate known violations of law, including regulatory law, even if it might make economic sense to do so in the board’s exercise of its business judgment. In the case of FXCM, the corporation may have taken a risk in violating the law that proved disastrous in a crisis. As the Court stated, “Where directors intentionally cause their corporation to violate positive law, they act in bad faith…. a fiduciary of a Delaware corporation cannot be loyal to a Delaware corporation by knowingly causing it to seek profits by violating the law.”

[1] According to Wikipedia, positive law consists of “human-made laws that oblige or specify an action,” from the verb “to posit,” as opposed to “natural law.”

[2] Exclusions for illegal conduct or violation of law, and possibly bad faith, would typically apply to directors’ and officers’ insurance policies as well.

James G. (Jay) McMillan is a partner in the Wilmington, Delaware office of Halloran Farkas + Kittila LLP. He concentrates his practice in complex corporate and commercial matters, with a particular focus on litigation in the Delaware Court of Chancery. For more information on the firm, visit hfk.law.

Another Good Reason Not to Oppose a Motion to Amend a Pleading in the Delaware Court of Chancery

By Jay McMillan

For good reason, it is unusual for a party in litigation in the Delaware Court of Chancery to oppose a motion to amend a complaint or other pleading. Under the Court’s Guidelines to Help Lawyers Practicing in the Court of Chancery (available here), parties are urged to agree to the filing of amended pleadings, but may reserve the right to file motions to dismiss the amended pleadings once filed. Following that procedure, the party opposing the amended pleading on a motion to dismiss (typically the defendant) gets to submit two briefs, one opening brief in support of the motion to dismiss and a reply brief in response to the plaintiff’s opposition brief. If the defendant chooses to oppose the amendment at the outset, it gets only one brief, an answering brief in opposition to the plaintiff’s motion to amend. Since two briefs are better than one, the defendant will typically follow the Court’s Guidelines and stipulate to the amendment, then move to dismiss the amended pleading. From the Court’s point of view, this procedure also precludes the defendant from taking two bites at the apple by first opposing the motion to amend, then filing a motion to dismiss if the plaintiff’s motion to amend is granted.

A motion to amend can be denied where amendment would be futile, that is, where the amended pleading would be dismissed under Rule 12(b)(6) for failure to state a claim upon which relief could be granted. Unless the party opposing amendment demonstrates that it will be prejudiced, a motion to amend may be reviewed under the same standard as a motion to dismiss. See Paine Webber v. Centocor, 1997 WL 30216, at *1, *3 (Del. Ch. Jan. 15, 1997) (Steele, V.C.). A defendant that stipulates to a motion to amend may thus assume that the standard for futility of amendment is the same as that for a motion to dismiss under Rule 12(b)(6).

A recent, unusual case provides another reason not to oppose a motion to amend a pleading, because there may in fact be a difference in the standards for futility of amendment and failure to state a claim. In a Final Report issued on September 22, 2017, in Apogee Investments, Inc. v. Summit Equities LLC, Civil Action No. 12897-MZ, Master in Chancery Morgan Zurn recommended that the Court grant a stockholder’s motion to amend a complaint in a books-and-records action. Master Zurn quoted NACCO Industries, Inc. v. Applica, Inc., 2008 WL 2082145, at *1 (Del. Ch. May 7, 2008), for the principle that a motion to amend may be denied under Court of Chancery Rule 15(a) “if the amendment would be futile, in the sense that the legal insufficiency of the amendment is obvious on its face.”

In Delaware, “legal insufficiency” under Rule 12(b)(6) occurs when relief could not be granted under any “reasonably conceivable” set of circumstances. See Central Mortgage v. Morgan Stanley Mortgage Capital Holdings, 27 A.3d 531, 536-37 (Del. 2011). If a motion to amend can only be denied where legal insufficiency is “obvious on its face,” that presents a lower hurdle for a motion to amend. Thus, it is possible for an amendment to clear the hurdle for a motion to amend and not clear the hurdle for a motion to dismiss. While the legal insufficiency of an amendment may not be “obvious on its face,” it may appear upon closer scrutiny on a motion to dismiss.

Given that the Court may be less receptive to a defendant’s motion to dismiss after it has granted a motion to amend over the defendant’s opposition, the defendant would be well advised to stipulate to the amendment and present its opposition to the amended complaint where the plaintiff faces the higher hurdle, on a motion to dismiss. Delaware’s “reasonably conceivable” standard is a low enough hurdle for a pleading party; legal insufficiency being “obvious on its face” is even lower. In Apogee Investments, Master Zurn found that the allegations of the proposed amendment were not “so obviously deficient on their face as to be deemed futile.” She concluded that the defendant’s opposition to the proposed amendment failed to overcome the “compounded liberal standards” for a motion to amend.

In short, it does not pay to oppose a motion to amend a pleading in the Delaware Court of Chancery. The Court may apply an extremely liberal standard to the motion, the opposing party is limited to a single brief in opposition to the motion, and the opposing party may be less likely to prevail on a subsequent motion to dismiss than it would be if it had stipulated to the amendment and reserved the right to move to dismiss.

 

James G. (Jay) McMillan is a partner in the Wilmington, Delaware office of Halloran Farkas + Kittila LLP. He concentrates his practice in complex corporate and commercial matters, with a particular focus on litigation in the Delaware Court of Chancery. For more information on the firm, visit hfk.law.