— Irving Olds, former chairman of Bethlehem Steel
In litigation decided in May by the Delaware Supreme Court, minority shareholders (who were frozen out through a merger engineered by a controlling stockholder) agreed with Old’s description, claiming that all the corporate directors of Cornerstone Therapeutics were useless in efforts to obtain a fair merger price for their shares.
The history of the case is a study in the evolving law of director liability.
Most larger corporations are formed in Delaware. Where there is a substantial merger, shareholder suits claiming breach of fiduciary duty follow in over 90 percent of cases (true for four straight years through 2013). Directors of Delaware corporations are getting sued continually.
The Delaware General Corporation Law permits corporate charters to eliminate liabilities of directors for breach of fiduciary duties owed to the corporation or stockholders unless the director is doing something wrong, e.g., has breached the duty of loyalty, acted in bad faith or with intentional misconduct, knowingly violated law, or derived improper personal benefit.
Delaware directors also are protected by the “business judgment rule.” A director can be wrong, reach an incorrect conclusion, and still avoid liability if free of wrong-doing and gross dereliction of duty.
But significant Delaware litigation has developed a different standard when directors have personal self-interest. Among other matters relating to self-interest, if a controlling shareholder, individual or corporate, effects a merger that freezes out the minority, that shareholder has an affirmative obligation to meet a so-called “entire fairness” standard: were the financial terms of the merger within a range of fairness to the minority?
Further, that shareholder’s representatives on target boards similarly must have their actions reviewed, in that the transaction itself was subject to an “entire fairness” test.
Cornerstone was a publicly traded company, in which an Italian drug manufacturer obtained a controlling stock position in 2009 and thereafter increased ownership to in excess of 60 percent.
In February 2013, the controlling shareholder offered to acquire all third-party Cornerstone stock at between $6.40 and $6.70 per share, which was over a 20 percent premium to market.
The controlling shareholder might have avoided analysis of whether its offer met the “entire fairness” standard if, pursuant to Delaware case law, it had specifically stated that its offer was conditioned on both the approval of an independent special board committee and a majority of minority shares, but did not do so.
Reporting U.S. companies must have a majority of its board “independent.” A majority of the Cornerstone board was thought by the entire board to be independent, and five “independent” directors were formed into a “special committee” to represent the target in the merger.
The special committee retained both a major law firm and a major investment bank. The directors spent seven months, held 37 meetings, and received seven “separate detailed financial presentations from its independent financial advisor.”
The special committee first requested $11 to $12 per share, which elicited a modest counter-offer of $8.25 per share and a statement that the controlling shareholder would go no higher.
In an exercise of hardball power, controlling shareholder’s CFO also advised the special committee that the majority shareholder had the right to fire all of them as well as the management team. Notwithstanding, the special committee rejected the offer and made a counter-proposal at $11, which was not accepted.
Shortly thereafter, Cornerstone missed its numbers for Q-1 2013. The special committee lowered its price to $10.25 per share and requested permission to shop the deal to third parties. Both elements of that offer were rejected.
Things continued to deteriorate for Cornerstone. In June, a major competitor announced a possibly competing drug and alleged that target’s patents were either invalid or would not be infringed.
The special committee dropped its offer to $9.75, elicited an August counter-offer of $9.25, and in September the parties agreed to $9.50 per share.
Immediately, Internet traffic began fomenting a class action suit on behalf of minority shareholders: might the price be inadequate; the controlling shareholder owned about 60 percent of the outstanding stock; one analyst had a $14 target for the Cornerstone shares; can the Cornerstone directors seek additional bidders; did the Cornerstone directors get an appraisal; will the upcoming proxy statement (not even then drafted) be accurate and complete about executive compensation?
Some minority shareholders joined class action suits, at no cost to themselves, against both the corporation and all directors.
Immediately, complaints were filed (one even in September) claiming breach of fiduciary duty. The company filed a preliminary proxy statement in October 2013.
At the stockholders’ meeting in early 2014, the merger agreement was approved by more than 80 percent of the minority stockholders, and the merger was effectuated.
The plaintiffs claimed breach of fiduciary duty against all the directors, including the independents. Directors affiliated with the controlling shareholder, which froze out the minority, clearly were subject to a suit on the merits to determine if they had breached their duty of loyalty, as the entire fairness standard applied to the transaction.
But the special committee of independent directors in effect said: “Wait a minute, we didn’t do anything wrong.” Although the controlling shareholder and its board representatives should be held to a review under entire fairness, the independent directors were entitled to charter exoneration at the pleading stage.
The independent directors have the benefit of the General Corporation Law, which permits exoneration from liability where directors did not breach a duty of loyalty, did not act in bad faith or in knowing violation of law, and did not derive improper personal benefit. No such allegation of breach, improper action or improper benefit was alleged against them, only that the transaction required entire fairness review.
Chancery Court 2014
In a rambling, informative Delaware Chancery Court opinion, Vice Chancellor Sam Glasscock III sympathized with the independent directors, noted the substantial efforts of the special committee, and observed the 80 percent affirmative vote of minority shareholders and that $9.50 gave a substantial premium over market.
Glasscock next noted that the burden of proof (given approval by the minority shareholders) shifted to the plaintiffs to disprove entire fairness, and that the burden of proof also shifted where an independent committee freely negotiates the transaction.
Nonetheless, the court held that where a transaction is subject to entire fairness, then no director can be afforded summary judgment (dismissal) until the matter has been litigated (even where no non-exculpated action has been pleaded against independent directors).
Having so decided, Glasscock did not have to deal with allegations that directors on the special committee were not independent; their independence did not matter for purposes of his decision.
Nor did Glasscock have to deal with the impact of the threat of firing all the directors, although he suggested in passing that the very existence of that threat might have coerced the directors who had a self-interest in remaining in office.
The decision thus left unevaluated the claim that a couple of the special committee members lacked independence in that they were involved in a company previously acquired by the controlling shareholder; and further, that the other “independent” directors were “hand-picked” by the target CEO.
Supreme Court 2015
The independent directors appealed to the Delaware Supreme Court, which, in May, reversed the decision as a matter of law on the theory that the charter provision exonerating independent directors from breach of fiduciary duty claims (absent wrong-doing) must be enforced.
If there is no allegation that a director specifically breached his duty of loyalty or derived improper personal benefit or intentionally committed misconduct or violation of law, then that independent director is entitled to be relieved from suit.
The fact that the whole transaction, and the liability of the controlling stockholder, will be subject to an entire fairness review is irrelevant to the exoneration of a truly independent director.
In the words of Chief Justice Leo E. Strine Jr., “… the mere fact a plaintiff is able to plead facts supporting the application of the entire fairness standard to the transaction, and can thus state a duty of loyalty claim against the interested fiduciaries, does not relieve the plaintiff of responsibility to plead a non-exculpated claim against each director who moves for dismissal.”
In so deciding, the Supreme Court did not comment on an interesting speculation contained in the Chancery opinion: that opening independent directors to non-dismissible suit could have the anomalous effect of making independent directors disinclined to serve on special committees, which are important to protect minority shareholders.
The tide is running in favor of directors generally, at least in Delaware. In June, Delaware amended its corporation statute to expressly permit a bylaw requirement that investors’ fiduciary breach of duty suits be brought only in Delaware.
Although Delaware law specifically prohibits a provision in the bylaws requiring losing plaintiffs to pay the winners’ attorneys’ fees, the forum-shifting provisions for litigation is yet another step in carving out rational protections for corporate directors who are sued even though they have exercised their honest judgment in protecting minority shareholders.
Stephen M. Honig is a lawyer at Duane Morris in Boston.