Chen v. Howard-Anderson: Chancery Court Describes Limits of Exculpation in Revlon Deals, Suggests Business Judgment if Vote Fully Informed

Practical Law Legal Update 8-564-5746 (Approx. 10 pages)

Chen v. Howard-Anderson: Chancery Court Describes Limits of Exculpation in Revlon Deals, Suggests Business Judgment if Vote Fully Informed

by Practical Law Corporate & Securities

Background

The case arises from the 2010 cash-and-stock acquisition of Occam by Calix, Inc. (see What's Market, Calix, Inc./Occam Networks, Inc. Merger Agreement Summary). The dispute had been the subject of a previous decision in which the court held at a hearing that a mixed-consideration merger should be subject to the enhanced-scrutiny standard under Revlon (see Legal Update, Delaware Chancery Court's Occam Ruling Applies Revlon to Mixed Consideration Transaction). The court repeated that ruling here by reference to the Smurfit-Stone decision (see Legal Update, In re Smurfit-Stone Container Corp.: Delaware Chancery Court Confirms Revlon Applies to Cash-and-stock Mergers).

Before the merger, Occam's stock was publicly traded on the NASDAQ. Its board consisted of seven directors, one of whom, Robert Howard-Anderson, was also the President and CEO. Of the remaining six directors, two, Steven Krausz and Robert Abbott, were affiliated with investment funds that held 15% and 10%, respectively, of Occam's common stock. All seven directors were defendants in the suit, as was the CFO, Jeanne Seeley, who was not a director but was instrumental in running the sale process. The company itself was also a named defendant.

In the months leading up to the merger, Occam's board weighed three different strategic alternatives with its financial advisors at Jefferies & Company, Inc.:

Selling to Calix for a mix of cash and stock consideration.
Selling to Adtran, Inc. for cash.
Remaining independent and acquiring Keymile International GmbH.

During discovery, the plaintiffs found several examples of conduct by the board that gave rise to inferences that it had unreasonably favored a transaction with Calix over the other two alternatives. Viewed in the light most favorable to the plaintiffs (the party not moving for summary judgment), the record after discovery indicated that the Occam board had:

Initiated contact with Calix and interacted regularly with Calix throughout the sale process.
Responded promptly to inquiries by Calix.
Quickly signed a non-disclosure agreement with Calix.
Barely negotiated over Calix's term sheet, without pushing strongly on price even as its own performance materially improved from the baseline assumptions that had informed the price.
Agreed to exclusivity with Calix and passively extended the exclusivity period on each of the three occasions when it expired.

Calix's own internal presentation also indicated that it viewed the price it paid as something of a bargain and that it would have been prepared to pay substantially more. The presentation also identified a possible schism among Occam's directors, with Calix believing that the directors affiliated with investment funds were more eager to sell so that their funds could move on to a new investment.

By contrast, Occam's negotiations with Adtran were not as welcoming. The record indicated that:

Occam did not provide Adtran with its management's projections, even though those projections were far stronger than those of two public analysts who followed Occam and even though those projections would have made Adtran more enthusiastic to bid.
Occam did not execute a non-disclosure agreement until five months after it was offered.
Howard-Anderson did not meet in person with Adtran's CEO for months after being invited.
Jefferies treated Adtran's preliminary bid as equivalent to Calix's, even though Adtran offered 11% more.

The record also indicated that Occam kept its own projections away from Jefferies, which made the sale alternatives more attractive and the standalone alternative less attractive to Jefferies than they otherwise might have been.

The plaintiffs emphasized two particular instructions from the board that would appear before trial to have been unreasonable. On June 30, 2010, the board instructed Howard-Anderson and Jefferies to give Adtran a 24-hour deadline to make a bid. Adtran's CFO described this as "a 24-hour gun to our head" and did not make a final bid. The board also instructed Jefferies that day to conduct a 24-hour market-check.

On July 1, 2010, the Thursday before the July 4th weekend, Jefferies sent e-mails to seven potential strategic buyers. The e-mails asked for a response within 24 hours and none mentioned Occam by name. In spite of this ambiguity and the compressed timeline, five of the seven companies responded with interest, though none were prepared to respond definitively so quickly. Occam did not further pursue any of the five companies' potential interests. These e-mail conversations amounted to Occam's entire market check, even though Jefferies had advised it months earlier to conduct a more robust process.

Occam and Calix signed their merger agreement on September 16, 2010. The proxy statement for the merger did not contain any revenue projections for 2012, even though they would have been material for evaluating Calix's offer. The plaintiffs also contended that the 2011 projections were inaccurately described in the proxy statement as providing projections for Occam on a standalone basis when in fact the projections assumed a merger with Calix that would cause Occam to lose an important account. The plaintiffs also pointed to other weaknesses in the proxy statement's description of the sale process.

Occam's stockholders approved the merger on February 22, 2011, with 64% voting in favor. Of the shares voting in favor, approximately 26% were obligated to do so under a support agreement. Of the non-obligated shares, 50.5% voted in favor of the merger.

After fact discovery closed, the defendants moved for summary judgment.

Outcome

For purposes of summary judgment, the court found reasonable inferences that the board had breached its fiduciary duty of care relating both to the sale process and the incomplete disclosures in the proxy statement. However, the court granted summary judgment in favor of the directors other than Howard-Anderson specifically with regard to their sale-process conduct, holding that they would be exculpated under the company's Charter for those decisions. The court denied summary judgment as to Howard-Anderson, for whom evidence existed that he had a conflict of interest, and denied summary judgment for Seeley, who was not exculpated because she was not a director. The court also denied summary judgment on the disclosures claim, holding that the motivations of the directors for making misleading disclosures could not be determined before trial and that bad faith could not be ruled out.

The court granted summary judgment for Occam itself, under the principle that it is the directors who owe fiduciary duties, not the company itself.

Revlon Standard Applied

The court began its analysis by describing the three typical standards of review for board conduct:

The business judgment rule, applicable to common decisions when the directors are disinterested and independent.
Enhanced scrutiny under Unocal for recognized situations of potential conflict.
Entire fairness when conflicts of interest are known to exist.

The court applied enhanced scrutiny, as dictated by Revlon for change-of-control transactions. The court noted that the parties had not raised any dispute over whether enhanced scrutiny should apply to officers who are not directors, in this case the CFO Seeley. The court therefore applied Revlon to Seeley as well, but noted the "lively debate" on this issue (see footnote 2). As the court explained, the Delaware Supreme Court has only ruled that officers have the same fiduciary duties as directors (Gantler v. Stephens, 965 A.2d 695, 709 (Del. 2009)), but has not addressed the standard of review for evaluating officer decision-making.

In an even more explicit signal of his readiness to take on a new issue, Vice Chancellor Laster suggested in dicta that a fully informed, non-coerced stockholder vote in favor of an acquisition should lower the standard of review for the board's sale-process conduct from enhanced scrutiny to business judgment. Vice Chancellor Laster cited several passages from recent cases that nod to this view, and cited to his forthcoming law review article on the subject (see footnote 9). In any event, the issue could not be addressed directly in this case because of the questions over the disclosures in the proxy statement.

The Outside Directors Were Independent

The plaintiffs contended that the transaction should be reviewed for entire fairness, arguing that directors Krausz and Abbott were beholden to their investment funds and that two other directors also had connections to those funds that compromised their judgment.

The court rejected this argument, noting that a conflict only arises if the interests of the director toward a certain party diverge from the interests of the stockholders to whom the director owes fiduciary duties. Here, however, the investment funds who appointed Krausz and Abbott and had connections to the two other directors had the same interests as the other stockholders of Occam. If a sale benefitted those funds, it would benefit the other stockholders equally, as would the company continuing on a standalone basis. A conflict only arises if a certain party stands to benefit in a way that the other stockholders do not.

The plaintiffs argued that one of the investment firms was particularly motivated to pursue a sale because its fund that had made the investment was scheduled to wind down. The court agreed that a need for liquidity can form the basis for a conflict of interest, but that this is not an automatic finding. Here, the investment firm had routinely extended the life of the fund in question, and Krausz had even raised the question of raising additional funds from it to acquire Keymile. The investment firm's interests therefore did not diverge from the other stockholders'.

The court did rule for purposes of summary judgment that Howard-Anderson was interested in the merger. Howard-Anderson personally received a large sum in benefits that were not shared by the other stockholders generally, including severance payments for a change of control. The court held that at this procedural stage, those benefits could be inferred as being material to Howard-Anderson.

Sale-process Conduct Outside the Range of Reasonableness

The court held, for purposes of summary judgment, that the decisions of the board during the sale process, including its favoritism toward Calix, its failure to develop the possibility of continuing on a standalone basis, the 24-hour ultimatum to Adtran and the 24-hour market-check, supported reasonable inferences of breaches of the duty of care.

The court noted that a board can permissibly favor one bidder if it believes in good faith that doing so would advance stockholder interests. However, any favoritism in a Revlon setting must be justified "solely by reference to the objective of maximizing the price the stockholders receive for their shares" (In re Topps Co. S'holders Litig., 926 A.2d 58, 64 (Del. Ch. 2007)). If the board, "under the sway of an overweening CEO... tilts the sales process for reasons inimical to the stockholders' desire for the best price," this will form the basis for a strong Revlon claim (In re Toys 'R Us Inc. Sholder Litig., 877 A.2d 975, 1002 (Del. Ch. 2005)).

Here, the court held that the record supported a reasonable inference that the board favored Calix at the expense of generating greater value through a competitive bidding process or by remaining a standalone company and pursuing acquisitions. The court added that this is not the only inference that could be drawn, nor even necessarily the strongest inference, but that it was a reasonable inference at the procedural stage.

Exculpation under Section 102(b)(7)

Occam's Charter contained a common provision for the exculpation of its directors under DGCL Section 102(b)(7) (8 Del. C. § 102(b)(7)). It is settled law that exculpation under the statute is only available for breaches of the duty of care, not for breaches of the duty of loyalty and not for breaches made in bad faith. Less well understood is how the distinction between business judgment and enhanced scrutiny affects not only the review of the board's conduct, but the availability of exculpation under Section 102(b)(7).

The director defendants argued that they must be exculpated because:

They were disinterested and independent.
They did not fail to act in good faith, because they did not knowingly and completely fail to undertake their responsibilities.

The court rejected this approach because it assumed that the directors were entitled to the presumptions of the business judgment rule. However, the directors' conduct was reviewed under enhanced scrutiny. This meant that the loyalty issue was whether the directors allowed interests other than obtaining the best value reasonably available for the stockholders to influence their decisions during the sale process, given that they made decisions falling outside of the range of reasonableness.

In arguing against summary judgment, the plaintiffs contended that where enhanced scrutiny applies, the court can draw an inference of bad faith if the directors have taken actions that fell outside the range of reasonableness. The directors responded that this is incorrect under Lyondell, which they read as holding that summary judgment must be granted in their favor unless they have "utterly failed to attempt to obtain the best price" (Lyondell Chem. Co. v. Ryan, 970 A.2d 235, 244 (Del. 2009)).

The court corrected the directors on their application of Lyondell to the issue at hand. The court recounted the judicial history of Lyondell at some length, beginning with the Court of Chancery's initial holding in Lyondell that Revlon imposed a known set of duties on directors faced with a merger proposal. By that understanding, a conscious disregard of those duties necessarily meant that the board had acted in bad faith. However, the Delaware Supreme Court explained on appeal in Lyondell that in fact, Revlon did not impose any particular duties, but only established a standard of review to examine the board's reasonableness. Post-Lyondell, the inquiry went from questioning whether disinterested, independent directors did everything they should have done to obtain the best price, to asking whether the directors utterly failed to attempt to obtain the best price.

With this background in mind, the court explained that the "utterly failed to attempt" standard is only relevant if the plaintiffs claim that the directors consciously disregarded known obligations imposed by Revlon. However, if the plaintiffs, as here, argue that the directors have succumbed to the situational conflict inherent in a change-of-control transaction by making decisions outside the range of reasonableness, the "utterly failed" retort is inapplicable. This is because Lyondell itself recognized that there are other theories of bad faith that have nothing do with a conscious disregard of responsibilities. These can include an argument of lack of due care stemming from "action taken solely by reason of gross negligence and without any malevolent intent" (Lyondell, 970 A.2d at 240).

No Evidence of Improper Motive

To establish a standard of bad faith that would not be entitled to exculpation, the plaintiffs invoked a different line of cases. They argued that a failure to act in good faith can be shown if the fiduciary intentionally acts with a purpose other than that of advancing the best interests of the corporation. The court accepted this standard, stating that the plaintiffs could defeat summary judgment with evidence that supported an inference that the directors made decisions that fell outside the range of reasonableness for reasons other than pursuit of the best value reasonably available, which could be no transaction at all.

In spite of accepting this standard, the court held that the factual record did not contain evidence sufficient to create a dispute of material fact about the outside directors' good-faith pursuit of the best value reasonably available. Although many of their decisions, for purposes of summary judgment, fell outside the range of reasonableness, the court did not find support for a reasonable inference that any of them were motivated by an improper influence. Similar to its analysis of the directors' independence, the court held that the outside directors were not subject to motives that diverged from the stockholders', but were motivated to obtain the best price reasonably available. Nothing on the record indicated that the investor-affiliated directors had acted against their own economic interests.

No Exculpation for Officers

Although it granted summary judgment in favor of the outside directors for their conduct during the sale process, the court denied summary judgment as to Howard-Anderson, who was personally conflicted, and as to the CFO Seeley, who was not a director. Currently, Section 102(b)(7) exculpation is only available for directors, not officers. The court, somewhat tellingly, cited again to Gantler v. Stephens, which stated that "although legislatively possible, there currently is no statutory provision authorizing comparable exculpation for corporate officers" (965 A.2d at 709, n.37).

The Disclosure Claim

The court denied summary judgment to the defendants for a determination that the disclosures in the proxy statement were accurate and that any information omitted was immaterial.

The court described the standard of materiality for disclosure. Under Delaware Supreme Court precedent, a fact is material if "there is a substantial likelihood that a reasonable shareholder would consider it important in deciding how to vote." Notably, this does not require a showing that disclosure "would have caused the reasonable investor to change his vote." Rather, the inquiry is whether there is a substantial likelihood that the disclosure "would have been viewed by the reasonable investor as having significantly altered the 'total mix' of information made available." (Rosenblatt v. Getty Oil Co., 493 A.2d 929, 944 (Del. 1985).)

The defendants argued that the omission of the 2012 revenue projections was immaterial because the projections were unreliable and speculative. The court stated that in a cash-out merger, reliable management projections typically are material, but that Delaware law does not require the disclosure of inherently unreliable or speculative information. However, when management projections are made in the course of business, they are generally deemed reliable (Cede & Co. v. Technicolor, Inc., , at *7 (Del. Ch. July 9, 2004), aff’d in part, rev’d in part, 884 A.2d 26 (Del. 2005)). At this stage, the court could not determine the reliability of the 2012 projections definitively.

The plaintiffs also argued that the proxy statement's description of the 2011 revenue projections was inaccurate and misleading. As the Delaware Supreme Court has held, "Once defendants travel down the road of partial disclosure, they have an obligation to provide the stockholders with an accurate, full, and fair characterization of those historic events" (Zirn v. VLI Corp., 681 A.2d 1050, 1056 (Del. 1996)). The court found evidence to support the plaintiffs' position on this and other potentially misleading disclosures.

Damages Recovery

The defendants argued that because the merger closed, and because it was not a short-form merger or a merger involving a controlling stockholder, the court could no longer award a remedy for a breach of the duty of disclosure. The court stated that this is an incorrect statement of current Delaware law, citing to its recent opinion in Orchard Enterprises. For more on that decision, see Legal Update, In re Orchard Enterprises: Court of Chancery Applies Entire Fairness to Controller Squeeze-out under MFW.

Practical Implications

The decision in Chen may end up being most significant for its various hints about the direction that the court wishes to see the law develop in, either judicially or legislatively. The court was most explicit that it would be prepared to lower the standard of review for Revlon deals from enhanced scrutiny to business judgment if the vote of the stockholders in favor of the transaction is fully informed and not coerced. The court also raised the dual issues of the standard of review and exculpation for officers who are not directors. While exculpation could only come from a statutory amendment, the court might be prepared to hear arguments for why non-director officers should be entitled to a more lenient standard of review.

The court's review of the connection between the enhanced-scrutiny standard of review and exculpation is also useful for practitioners. The decision reminds that the theory for a finding that the directors are not exculpated by Section 102(b)(7) in Revlon deals cannot necessarily be defeated by a showing that the directors simply did not utterly fail to attempt to obtain the best possible price. Rather, the plaintiffs only have to bring evidence that supports an inference that the directors made decisions that fell outside the range of reasonableness for reasons other than pursuit of the best value reasonably available.

It is also worth keeping in mind that in light of the recent Rural/Metro decision, just because the directors may be exculpated under the company's Charter, does not mean that the underlying conduct vanishes. Other parties can still be held accountable for the same underlying conduct, like the financial advisors in Rural/Metro and the CFO in Chen.

Chen v. Howard-Anderson: Chancery Court Describes Limits of Exculpation in Revlon Deals, Suggests Business Judgment if Vote Fully Informed | Practical Law