The Delaware Supreme Court’s recent decision in Singh v. Attenborough (May 6, 2016, en banc, “Zale III”), written by Chief Justice Leo E. Strine, Jr., is consistent with the trend of Delaware decisions that, as a practical matter, have significantly narrowed the risk of directors being found to have breached fiduciary duties in M&A transactions. The decision is most notable, however, for apparently reversing the momentum of recent Delaware decisions that have been interpreted as potentially expanding the risk of aiding and abetting liability for M&A financial advisors.

Key Points

• Lower risk of aiding and abetting liability for bankers. Most importantly, the Court’s commentary in the decision emphasizes that bankers generally should not have aiding and abetting liability except in unusual circumstances involving knowing bad faith conduct.
• Likely no effect on risk of liability for directors. The decision likely will have no effect, as a practical matter, on the risk of liability of directors—who, due to exculpation, do not face liability for breaches other than those that involve bad faith.

Background

Zale I. After the closing of the sale of Zale Corporation to Signet Jewelers, former Zale stockholders sued for damages, claiming (i) that the Zale directors had breached their duty of care in the sale process by not discovering (before the deal price was agreed) that Zale’s financial advisor (BAML) had a potential conflict of interest due to a prior pitch BAML had made to Signet about a possible acquisition of Zale and (ii) that BAML had aided and abetted the breach. The facts that the prior pitch had been made, that it included a valuation of Zale the top end of which matched the deal price, and that the same senior banker led the pitch team and the sell-side representation, were disclosed in the proxy statement. The Court of Chancery (Zale Stockholders Litigation, Oct. 1, 2015, “Zale I”), evaluating the Zale board’s conduct under Revlon enhanced scrutiny, dismissed the claims against the directors because, under the Zale charter, they were exculpated from liability for duty of care violations, but refused to dismiss the aiding and abetting claims against BAML for the directors’ alleged breaches.

Corwin. The day after Zale I was decided, the Delaware Supreme Court issued Corwin. Corwin held that, in a post-closing damages action relating to a transaction that was approved by the stockholders in a fully informed and un-coerced vote, the business judgment rule would be the standard of review—regardless of what standard of review (e.g., the heightened scrutiny standards of Revlon or Unocal) applied pre-closing (in a motion for a preliminary injunction). The only exception would be in the case of a transaction that was subject to the “entire fairness” standard of review—that is, a controller transaction that did not meet the MFW prerequisites for business judgment review (including approval by the disinterested stockholders in a fully informed, un-coerced vote).

Zale II and Zale III. In light of Corwin, BAML moved for re-consideration of the Zale I ruling, arguing that, given the fully informed approval of the transaction by the Zale stockholders, the court should have applied business judgment review (rather than Revlon, which had applied pre-closing). Ruling on that motion (Oct. 29, 2015, “Zale II”), Vice Chancellor Parsons, based on Corwin, reversed himself and dismissed the claims against BAML. In Zale III, the Delaware Supreme Court affirmed the dismissal.

Discussion

“Corporate waste” standard reduces somewhat the likelihood of a finding of a breach by directors—but likely will have no effect on the risk of liability of directors. Amplifying its seminal 2015 Corwin v. KKR Financial decision, the Court clarified that, when disinterested stockholders have approved a transaction in a fully informed vote, the legal standard that will apply, under business judgment review in a post-closing action for damages, is “corporate waste” (rather than “gross negligence”). The Court reasoned that, under business judgment review, the standard for finding a breach should be higher (i.e., it should be even more difficult to establish a breach) where stockholders have approved a transaction than where they have not. While the gross negligence standard represented a high bar to a finding of breach, the corporate waste standard represents an even higher bar.

Indeed, the Court characterized the corporate waste standard, in the context of review under the business judgment rule after disinterested stockholder approval of a transaction in a fully informed vote, as “vestigial” and having long held “little real-world relevance” in the context of a stockholder-approved transaction, “because it has been understood that stockholders [when fully informed] would be unlikely to approve a transaction that is wasteful.” Thus, the Court stated, in a Corwin post-closing action, absent corporate waste or materially inadequate disclosure, dismissal of fiduciary duty claims at the motion to dismiss stage will be “the typical result.” The shift in standards should not, however, as a practical matter, affect directors’ liability for breaches—because virtually all directors are, in any event, exculpated (under company charter provisions, as permitted by Delaware law) from liability for all breaches that do not involve bad faith conduct (i.e., all breaches other than breaches of the duty of loyalty).

Lower risk of liability for bankers.

• “Corporate waste” standard decreases the likelihood of a finding that there was a breach by directors. As noted, the shift to the corporate waste standard in a Corwin post-closing action, reduces even further the likelihood of a finding that there was a breach by directors—which, in turn, lowers the likelihood of a finding that there was a breach (even if exculpated) that bankers aided and abetted.
• Confirmation that Corwin will apply to aiding and abetting claims. The Court confirmed that, in the context of a post-closing review under the business judgment rule of a transaction approved by the disinterested stockholders in a fully informed vote, aiding and abetting claims typically would be dismissed early in the litigation, absent bad faith conduct by the banker.
• Court’s comments emphasized a low risk of liability for bankers. In dicta, the Court emphasized that bankers should not have aiding and abetting liability absent “bad-faith actions” involving “scienter” (which involves some form of intentional or knowing conduct, and is a required element of an aiding and abetting claim). “Delaware has provided advisors with a high degree of insulation from liability by employing a defendant-friendly standard that requires plaintiffs to prove scienter… [and the scienter requirement] awards advisors an effective immunity from [their own lack of due care],” the Court observed. Further, the Court stated that “scienter” on the part of a banker may be inferred where there is egregious conduct by the banker—and the Court expressed “skepticism” about the Court of Chancery’s conclusion (in Zale II) that it was rational to infer scienter based on the advisor’s late disclosure of a potential conflict of interest due to a prior pitch. We note, further, that the Delaware Supreme Court, in December 2015, in the appeal of Rural Metro, rejected the concept that financial advisors may be “gatekeepers” in the M&A process.

Heightened importance of disclosure. The decision underscores the importance of materially adequate disclosure. First, as noted, under Corwin, the application of business judgment review, post-closing, is predicated on there having been a “fully informed” stockholder vote—thus, meritorious claims of inadequate or misleading disclosure in the proxy statement could rule out application of business judgment review and prevent dismissal of claims. Second, we note that, in Zale, timely disclosure by the financial advisor to the board of the potential conflict represented by the prior pitch (i.e., at or soon after the banker’s engagement by Zale) should have mitigated, if not obviated, the claims made by the Zale stockholders. Third, we note that, in Zale, the advisor’s potential conflict due to the prior pitch—while not disclosed prior to the agreement with Signet having been reached—was disclosed to shareholders in the proxy statement. If it had not been, the judicial result may well have been different. If a potential material conflict is not disclosed to stockholders prior to the vote on the transaction (or is disclosed, but the disclosure is deemed by the court to have been inadequate), then it would be unlikely that the Corwin shift to business judgment review (and resulting dismissal of claims) would apply.

Continuing importance of good practice by bankers. While the decision provides significant comfort to investment banks that they should not have aiding and abetting liability absent willful, bad faith conduct by the bankers and materially inadequate disclosure by the target company to its stockholders, at the same time, the Court: (i) confirmed that the conduct by the banker in the Rural Metro litigation was sufficiently egregious that it would have given rise to aiding and abetting liability even in the case of a transaction that had been approved by the disinterested stockholders in a fully informed vote; and (ii) confirmed that bankers may have aiding and abetting liability for directors’ breaches even when the directors themselves are exculpated from liability for the breaches and dismissed from the litigation.

Further, the Court appears to have suggested a new concept that bankers possibly could have aiding and abetting liability even when there has been no underlying breach of duties by the directors. Referring to the Rural Metro situation, the Court commented that the banker in that case had “intentionally duped” the board and the board, in good faith, had “relied on the misleading and incomplete advice [that was provided by the banker and that was] tainted by the advisor’s own knowing disloyalty.” To absolve a banker’s willful, bad faith conduct in this situation would be “unprincipled,” the Court stated—although, we note, that if the directors acted in good faith and were reasonably diligent, there would not be any underlying director breach of fiduciary duties.

What conduct by a financial advisor would give rise to liability? The Court suggested that Rural Metro was an unusual case that did involve conduct by the advisor that would be sufficient for a finding of liability even under business judgment review where there had been fully informed disinterested stockholder approval. In Rural Metro, in the words of the Court of Chancery in that case, the advisor, “propelled by its own motives” (primarily, to obtain financing and other engagements from the buyer) had “intentionally duped” the target company board (when determining the timing and nature of the sale process), while also having deliberately concealed other actual or potential conflicts (including with respect to its efforts to provide stapled financing to the buyer and to provide financing to buyers of a competitor of the target company, as well as its leaking information about the sale process and valuation to the buyer).

In addition to the critical conflict issues in Rural Metro, the Court of Chancery found that the advisor had deliberately manipulated the financial analyses and other information provided in order to persuade the board to approve the merger; had produced only very limited information for the target board (including not providing a valuation of the company as an independent concern); had provided the information to the board only hours before the board meeting at which the merger was approved; and had provided disclosure for the merger proxy that included material omissions and misstatements.

Open issues.

• Applicability of post-closing business judgment review when the board was not independent and disinterested or there are claims for bad faith breaches. The extent to which there may be limits to application of the business judgment rule in a Corwin setting when the board is not independent or not disinterested, or when the claims are for bad faith breaches that are un-exculpated, awaits further judicial development. In dicta in the Court of Chancery’s Corwin decision, Chancellor Bouchard suggested that the shift to business judgment, post-closing, under Corwin, would occur even in the case of a board that had been neither independent nor disinterested. The Delaware Supreme Court did not address the issue in its Corwin decision or in Zale III. The question arises whether a claim for an un-exculpated, bad faith breach (i.e., a breach of the duty of loyalty) would be dismissed, under Corwin, based on the disinterested stockholders’ informed approval of a transaction—even in the face of credible claims that the directors were motivated by their personal interests and not by corporate interests. If the Court concludes that, based on disinterested stockholder approval, non-exculpated claims would be subjected to the business judgment standard and likely to be dismissed at an early stage of litigation, that would significantly lower the liability risk for directors (by subjecting claims that are non-exculpated to a standard that represents an extremely high bar to liability).
• Possible further refinement of applicable concepts. We note that it remains to be seen whether, in the context of post-closing business judgment review based on stockholder approval, there will be any modifications of the relevant legal concepts—such as an expanded view of what constitutes adequate disclosure for a “fully informed” stockholder vote, or a narrowed view of who is an “interested” stockholder—given the underlying emphasis of the Court on the ratifying effects of stockholder approval.

Practice Points

• Importance of best practices relating to a sale process. Notwithstanding Corwin and Zale III, best practices by boards and bankers in conducting a sale process—including with respect to bankers’ disclosure of actual and potential conflicts of interest and avoiding actions that could be deemed to intentionally harm or defraud the board—will continue to advantage all parties, for reasons relating to business reputation, as well as potential legal liability.
• Practical impact of different pre- and post-closing standards of judicial review. We note that, even when, under Corwin, business judgment review may apply post-closing, the board will have to plan and manage the sale process to pass muster under the standard of review that will be applicable pre-closing. For example, if a transaction is subject to the enhanced scrutiny of Revlon pre-closing, then, to avoid the transaction being enjoined pre-closing, the board will have to have fulfilled its Revlon duties—even though the court will apply business judgment review (and not Revlon) in a post-closing damages action. Thus, as a practical matter, Corwin and Zale III should not affect pre-closing planning of a transaction.
• Importance of materially complete disclosure when seeking stockholder action. As noted, Zale III serves as a reminder of the importance of materially complete disclosures in connection with stockholder votes, given that a “fully informed” vote is a predicate of business judgment review under Corwin. Indeed, where stockholders bring a preliminary injunction action, pre-closing, challenging the adequacy of disclosures, director and corporate defendants will have the incentive to make supplemental disclosures mooting such claims not only to avoid the risk of an injunction, but to maximize the likelihood of application of the business judgment rule (and thus early dismissal of claims) in any damages action brought post-closing.
• Tactical considerations regarding disclosure. Stockholder-plaintiffs who believe that they have meritorious disclosure claims may decide not to press such claims in a pre-closing injunctive proceeding, based on an expectation that, if a post-closing damages action is brought, the claims could then be asserted to support the proposition that the stockholder vote was not fully informed and that business judgment review therefore would not be applicable. Moreover, there may be added incentive not to press claims pre-closing, based on the courts’ recent rejection of disclosure-only settlements unless the supplemental disclosure is “plainly material.” We note that defendants may argue that any claims that were known but not pressed pre-closing were effectively waived.

This memorandum was originally published by Fried Frank on May 23, 2016 and is available here.