Delaware Supreme Court Provides New Guidance for Directors and Officers Evaluating a Corporate Sale or Restructuring

A recent decision by the Delaware Supreme Court, Gantler v. Stephens, C.A. No. 2392 (Del. January 27, 2009) (available here) provides new guidance for directors and officers on their fiduciary duties arising in connection with a possible corporate sale or restructuring.  In Gantler, the Court held that directors and officers of an Ohio bank (the “Bank”) could be found to have breached their fiduciary duty by rejecting an opportunity to sell the Bank and instead pursuing a recapitalization that favored the insiders. The case was brought by a former director (Gantler) and minority shareholders of First Niles Financial, Inc. (“First Niles”), the Bank’s holding company. 


In short, the historical position under Delaware corporate law has been that certain conflicts of interest of insiders (such as trying to keep one’s employment or directorship) are inherent and unavoidable, and if properly disclosed, would not result in a higher level of scrutiny from courts over board decisions.  Gantler holds that this is not always true, and that specific facts can alter that position. 


Specifically, where directors and/or officers are — or with 20/20 hindsight, may be argued to be — motivated to prefer one particular transaction over another, even if the motivation is reasonable and disclosed to shareholders, extreme care should be taken to ensure that the board evaluation and deliberation process is balanced and well-documented.  Failure to do so may prevent a board from being entitled to the business judgment rule and subject the directors and officers to a stricter standard that the actions meet the “entire fairness” test under Delaware law.


After a strong acquisition market, in August 2004, the First Niles board agreed to put the Bank up for sale and hired investment bankers to pursue the opportunity.  Shortly thereafter, the managing officers of First Niles (and the Bank), several of whom were also directors, advocated that the Bank abandon the process and privatize the company by delisting from the NASDAQ SmallCap Market.  The Bank received offers from three strategic purchasers, each considered by the bankers to be within the recommended range.  Two offers made clear that the purchaser would terminate the incumbent First Niles board upon closing.  In the months that followed, management did not respond to the bidders’ due diligence requests and delayed the process (resulting in the withdrawal of one bid, which was not disclosed to the board until after the fact) and continued to discuss the privatization proposal.  In March 2005, notwithstanding a favorable opinion from the bankers as to one of the offers, the board voted 4 to 1 to reject the offer, with Gantler being the only dissenting vote, and turned its attention to the privatization plan. 


In April 2005, management presented to the board its privatization proposal, which would reclassify the First Niles common stock held by holders of 300 or fewer shares into a new class of Series A Preferred Stock that would pay higher dividends and have the same liquidation preference as the common stock, but that would not have voting rights except in the event of a proposed sale of the company.  In December 2005, the proposal was approved 3 to 1 by the Board, with Gantler again being the only dissenting vote.  Shortly thereafter, Gantler was replaced on the Board by an officer of the company.  The following June, the newly-composed First Niles Board unanimously approved a charter amendment to effect the reclassification and proceeded with the proxy solicitation process for shareholder approval.  The proxy statement did disclose that the directors and officers had a conflict of interest with respect to the reclassification and the alternative transactions that the board had considered, including a business combination that was turned down.


Following shareholder approval of the charter amendment, the plaintiffs brought suit in the Delaware Chancery Court alleging, among other things, that the board violated its various fiduciary duties by sabotaging due diligence and abandoning the sales process in favor of their own incumbency.  In March 2008, the Chancery Court dismissed the case for failure to state a claim and the parties appealed. 


In reversing the Chancery Court’s dismissal, the Supreme Court clarified several issues of Delaware corporate law, including the following:


§         Higher Scrutiny for Transactions with Potential Conflict of Interest.  The Court agreed with the defendants that the Board’s duty in this case should be analyzed under the more favorable business judgment rule, as opposed to the “enhanced scrutiny” standard under Unocal.


However, the Court did hold that the business judgment presumption could be rebutted in this case because reasonable inferences of self interest could be drawn from the defendant directors’ and officers’ lack of cooperation with the due diligence requests and sabotaging of the bid process.  In its analysis, the Court highlighted the specific conflicts arising from a sale of the Bank for each of the directors — the potential loss of employment for the Chairman/CEO; and the loss of the Bank as a key client for businesses operated by two different directors.  It is also interesting to note that the Court relied on the disclosure in the proxy statement of the potential for conflict of interest as an admission that the conflict did in fact exist.


There can be little question that the extreme facts of this case heavily influenced the Court’s decision to rebut the presumption of good faith by the board, and that the outcome may have been different if the some of the “sabotaging” activity was not present and if the board deliberations regarding the sale proposals were more extensive.  The Court specifically noted that after only one bidder remained and the bankers opined that the bidder may continue to improve their offer, the board did not discuss the offer at one meeting and rejected in another, “without discussion or deliberation.”


If directors or officers do have personal financial interests that diverge from the interests of other shareholders, a board should now be prepared for a higher standard of review of their actions.  That said, Gantler should not be read to require a board to reach any particular decision (e.g. sell, recapitalize, etc.), but only that the process to reach that decision is fair and informed.  Therefore, to the extent that certain opportunities can later be reasonably argued to have been more preferable for certain (minority) shareholders, boards should be advised to more carefully evaluate those opportunities and to document why they may not have been in the best interests of all shareholders.


Where a potential conflict does exist, boards should be advised to consider the appointment of an independent committee for the M&A process, where such committee would have the authority to engage its own advisors and independent legal counsel.  Another approach may be to engage multiple investment banking advisors to provide a board with a comparative analysis of the opportunities.  Finally, extreme care should be take to distribute all studies, reports and materials in advance of board meetings, to have substantive discussions on those issues at the meetings and properly memorialize in the minutes to evidence that the board fulfilled its duty of care (which it would seem was not met in Gantler). 


§         Fiduciary Duty of Officers equal to that of Directors.  As an issue of first impression, the Court held that officers of a Delaware corporation have the same fiduciary duties as directors.  While this position has been implied, the Supreme Court has now explicitly held that officers owe fiduciary duties of care and loyalty that are the same as those of directors of Delaware corporations. 


§         Shareholder Ratification Limited.  The Court also disagreed with the Chancery Court’s finding that the shareholder approval of the privatization plan, as submitted by the First Niles board and described in the proxy, “ratified” the prior actions of the board, absolving them of liability.  To clarify this area of the law, the Court imposed a number of specific limitations on this doctrine. 


First, shareholder ratification is effective only where a “fully informed shareholder vote approves director action that does not legally require shareholder approval in order to become more legally effective.”  Therefore, where a shareholder vote is otherwise required – such as for the approval of a charter amendment or a merger – the shareholder vote does not carry any ratifying effect of the preceding board action. 


Second, the only director action that can be ratified is that which shareholders are specifically asked to approve. For example, the ultimate approval of a merger by shareholders does not mean that shareholders have also ratified all related director actions, such as defensive measures that may have been taken in the context of that transaction.


Third, the effect of shareholder ratification does not extinguish all claims in respect of the ratified director action, but rather subjects the challenged action to business judgment review (as opposed to the entire fairness test).  Therefore, companies should not assume that a valid shareholder vote would sanitize the prior actions of a board in connection with any particular corporate decision or transaction.


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