The current economic upheaval that our nation faces is redefining the risks and rewards of service to public corporations. In this economic climate, it is imperative for directors and officers to review and consider their own standards of performance and exposure to liability.
The Delaware Supreme Court's January 27, 2009 decision in Gantler v. Stephens demonstrates how corporate decisions may now be subjected to greater court scrutiny. In a rare reversal of the Chancery Court, the Delaware Supreme Court exhibited greater willingness to second-guess corporate decisions by accepting the plaintiff shareholders' rebuttal to the business judgment presumption in the context of a rejected merger offer and a going private transaction. Equally significant, the Delaware Supreme Court:
• for the first time, explicitly held that officers of Delaware corporations owe shareholders the same fiduciary duties of care and loyalty as directors, and
• held that the common law doctrine of "shareholder ratification" is limited to (i) director actions that do not require shareholder approval to become effective and (ii) director actions or conduct that is expressly submitted to the shareholders for ratification.
In Gantler , the Board of Directors of a publicly traded bank holding company, First Niles Financial Inc., sought to sell its banking business. The corporation received three competing bids. The Board of Directors decided to pursue two of the bids. The investment bank retained by the corporation opined that the three bids were favorable. One of the bids fell through after management failed to comply with the bidder's due diligence requests, and the other bid was rejected by the Board of Directors without any discussion or deliberation by the Board.
After the failed sale process, the Board voted to take the corporation private through the reclassification of certain shares. In its proxy statement seeking authority for the reclassification, the Board disclosed that each of the directors and officers had a conflict of interest with respect to the reclassification and that the Board had received a firm merger offer, but that after careful deliberations, it had determined that such offer was not in the corporation's best interest or its shareholders' best interest and thus, the Board had rejected the merger offer. The shareholders approved the reclassification.
After the transaction's approval, plaintiff shareholders brought an action claiming that the corporation's directors and officers breached their fiduciary duty by (1) rejecting the merger offer and abandoning the sales process, (2) disseminating a materially false and misleading reclassification proxy, and (3) implementing the reclassification. The Delaware Chancery Court dismissed all three claims. On appeal, the Delaware Supreme Court reversed all three rulings.
Director Liability: Business Judgment Rule And Entire Fairness Review
As to the first claim, concerning the Board of Directors' rejection of the merger offer and abandonment of the sales process, the Delaware Supreme Court held that the plaintiff shareholders' rebutted the presumption of the business judgment rule1by making a cognizable claim that a majority of the Board acted disloyally. The plaintiff shareholders pled sufficient facts to conclude that (1) one director (who was also an officer) was conflicted because, in order to preserve his position with the company, he had attempted to "sabotage" the sale process by not responding to due diligence requests from bidders and (2) the other two directors were conflicted because they were associated with companies that did business with the corporation.
The court noted that allegations of a director's desire to retain his or her position and pay as director are insufficient on their own to rebut the business judgment presumption. However, where the director's alleged disloyalty is supported by additional facts, such as ignoring due diligence requests, the business judgment presumption may be rebutted and instead, entire fairness review is applied. The court also affirmed that the entire fairness standard is applicable in a non-transactional context and that the Board's actions are not insulated from an entire fairness review because the Board did not implement defensive measures.
Lesson: Boards considering corporate restructuring transactions, such as going private, in which a majority of its directors have a potential conflict of interest, should implement measures to ensure that the Board's actions satisfy an entire fairness review.
Turning its attention to the breach of fiduciary duty claim against the corporation's officers, the court held that the plaintiff shareholders established sufficient facts to make a cognizable claim that the corporation's officers acted disloyally. In its analysis, the court explicitly held that officers owe fiduciary duties of care and loyalty, and that such fiduciary duties of officers are the same as those of directors.2
Of interest is the court's comment that the consequences of a director's or officer's fiduciary breach would not necessarily be the same. As an example, the court noted that while under Del. Code. Ann. tit. 8, §102(b)(7), a corporation's certificate of incorporation may, in certain circumstances, exculpate a director from personal liability for monetary damages in a breach of fiduciary duty claim, there is no current statutory provision authorizing comparable exculpation of corporate officers.3
Lesson: Officers of Delaware corporations are subject to the same fiduciary duties as directors, including a duty of loyalty and a duty of care.
Narrowing Of The Common Law "Shareholder Ratification" Defense
With regard to the breach of fiduciary duty claim concerning the reclassification of shares, the court rejected the common law "shareholder ratification" defense. The court clarified that the shareholder ratification doctrine is limited to the "classic" situation in which "a fully informed shareholder vote approves director action that does not legally require shareholder approval in order to become legally effective."4 Therefore, because shareholder approval was statutorily required prior to the reclassification's taking effect, the shareholder ratification defense was not available to the defendants. In addition, the court emphasized that shareholder ratification is limited to those director actions or conduct that shareholders are specifically requested to approve.
Lesson: The common law "shareholder ratification" doctrine does not apply to Board actions that legally require shareholder approval, such as the authorization of amendments to a certificate of incorporation.
To effectively claim the "shareholder ratification" defense, shareholder approval has to be fully informed. In this particular case, shareholder approval was found not to be fully informed because the proxy statement describing the reclassification was materially misleading. The court concluded that the proxy statement was materially misleading because it falsely asserted that the Board had rejected the merger offer after "careful deliberations."
Finally, the court explained that the shareholder ratification defense, when properly applied, does not extinguish all claims concerning the directors' actions, but subjects the challenged action to business judgment review. The shareholder ratification defense can only extinguish claims that assert that the directors lacked the authority to take an action later ratified by the shareholders. In addition, the court noted that void acts, such as fraud, gift, waste and ultra vires acts, authorized by the Board of Directors can only be ratified by a unanimous shareholder vote.
Lesson: A Board of Directors seeking to avail itself of the shareholder ratification defense must expressly request the shareholders to ratify the action at issue. Ratification of acts taken by the Board of Directors that would otherwise be deemed void require unanimous shareholder approval. 1 The presumption that directors act on an informed basis and in good faith when making business decisions.
2 The Supreme Court of Delaware had implied that officers and directors had the same fiduciary duties in the past, but Gantler made this explicit.
3 We note that some states, including New Jersey, permit the corporation's certificate of incorporation to limit the liability of officers. Other states, including New York and Connecticut, do not expressly authorize limits on officer liability in the certificate of incorporation.
4 The court notes that its opinion is not intended to affect or alter jurisprudence concerning the effect of an approving vote of disinterested shareholders under Del. Code. Ann. tit. 8, § 144 (interested director transactions).
David A. Swerdloff is Co-chair of Day Pitney's Corporate and Business Law Department. Ronald H. Janis is a Partner in the Corporate and Business Department of the firm, and the leader of the Mergers, Acquisitions and joint Ventures Practice Group. Elida Salcedo is an Associate in the firm's Stanford office.