In a decision on the consolidated appeal of the Delaware Court of Chancery's decisions in Cornerstone Therapeutics and Zhongpin, the Delaware Supreme Court reversed and remanded each case back to the Court of Chancery, holding that there is no automatic inference of disloyalty on the part of disinterested and independent directors just because they facilitate a transaction with a controlling stockholder. The decision of the Supreme Court establishes that even when a transaction is subject to entire fairness review, the disinterested and independent directors who negotiated the transaction can win pre-trial dismissal of any claims brought against them if they are exculpated by a 102(b)(7) charter provision and the plaintiff has failed to plead facts that support a non-exculpated claim against them (In re Cornerstone Therapeutics S'holder Litig., No. 564, 2014 (Del. May 14, 2015); Leal v. Meeks, No. 706, 2014 (Del. May 14, 2015)).

The factual background and legal issues of the Cornerstone case are detailed in Legal Update, In re Cornerstone Therapeutics: Dismissal under 102(b)(7) Unavailable to Independent Directors when Entire Fairness Applies. In a decision on a motion to dismiss, the Court of Chancery grappled with the issue of whether a charter exculpation provision under DGCL Section 102(b)(7) does not entitle disinterested and independent directors to pre-trial dismissal of claims brought against them, even when the claims do not actually plead any facts to support a non-exculpated breach, simply by virtue of the directors' involvement in a transaction with a controlling stockholder that will be reviewed for entire fairness (C.A. No. 8922–VCG, (Del. Ch. Sept. 10, 2014)).

In arguing for a denial of the motion, the plaintiffs reasoned that when the applicable standard of review for the transaction is entire fairness, the court must hold off on dismissing the claims against the disinterested and independent directors, in spite of the exculpation provision. The plaintiffs contended that even if they have not made particularized allegations that the directors themselves breached a fiduciary duty, the directors must remain defendants in the litigation as long as the plaintiffs have pled:

The defendants responded that an entire-fairness claim against the controlling stockholder does not relieve the plaintiffs of their obligation to plead a specific claim against each of the disinterested and independent directors.

The plaintiffs' doctrinal argument was based on a premise that they should be entitled to an automatic inference that a director facilitating an interested transaction is disloyal because the possibility of conflicted loyalties is heightened in controller transactions, and the facts that give rise to a duty of loyalty breach may be unknowable at the pleading stage. The Court of Chancery gave some credit to this theory, acknowledging that directors' loyalties are often "cryptic and unknowable" at the pleading stage in controller transactions where there is no developed record.

Overall, though, the Court of Chancery was more sympathetic to the defendants' viewpoint. The Court of Chancery stated in its decision that "doctrinally it seems insufficient" to capture disinterested and independent directors with pleadings that they simply participated in a transaction with a controller and to allow a general inference of disloyalty to overcome a motion to dismiss. This standard would create a disincentive for directors to serve on special committees of independent directors because it would be impossible for them to avoid any litigation over the transaction that involves the controller. Their incentive instead would be to refuse to participate in the negotiation of the transaction altogether. The Court of Chancery added that the inference of disloyalty would seem to run counter to the policy underpinnings of the Delaware Supreme Court's opinion in M&F Worldwide, which suggests that an assumption of unfairness can be overcome when the transaction is negotiated by a special committee of disinterested, independent directors who are empowered to reject the transaction and is conditioned on majority-of-the-minority approval (Kahn v. M&F Worldwide Corp., 88 A.3d 635 (Del. 2014); see Practice Note, Fiduciary Duties of the Board of Directors: Avoiding Entire Fairness Review by Employing Procedural Protections).

In spite of its misgivings, however, the Court of Chancery felt compelled to rule in the plaintiffs' favor, because it agreed with the plaintiffs' reading of the Delaware Supreme Court's decision in Emerald Partners II (Emerald Partners v. Berlin, 787 A.2d 85 (Del. 2001)). In Emerald Partners II, the Supreme Court stated that "when entire fairness is the applicable standard of judicial review, a determination that the director defendants are exculpated from paying monetary damages can be made only after the basis for their liability has been decided" (787 A.2d at 94). The basis for liability is decided only when there is a fully developed factual record as to whether the transaction was entirely fair, which is after a trial.

The Court of Chancery had also noted a certain incongruity in the case law between Emerald Partners II and several Court of Chancery decisions that were subsequently upheld by the Delaware Supreme Court and which apparently supported the defendants' view. Primarily, in Southern Peru the Court of Chancery stated that, "[u]nless there are facts suggesting that the directors consciously approved an unfair transaction... the more stringent, strict liability standard applicable to interested parties is critically different" than the standard applicable to the directors on the special committee (In re S. Peru Copper Corp. S'holder Deriv. Litig., 52 A.3d 761, 787 n.72 (Del. Ch. 2011), aff'd sub nom., Americas Mining Corp. v. Theriault, 51 A.3d 1213 (Del. 2012)).

In light of the importance of the issue and the lack of clarity in the common law, the Court of Chancery granted interlocutory appeal of the case ( (Del. Ch. Sept. 26, 2014); see Legal Update, Interlocutory Appeal Granted in Cornerstone Therapeutics on Issue of Liability for Independent Directors). Two months later and faced with the same issue, the Court of Chancery in Zhongpin deferred to Cornerstone's interpretation of precedent and held that the claims against the independent directors survived their motion to dismiss "regardless of whether the Complaint state[d] a non-exculpated claim" because the transaction was subject to entire fairness review (In re Zhongpin S'holders Litig., , at *12 (Del. Ch. Nov. 26, 2014)).

The Delaware Supreme Court accepted the interlocutory appeal and ruled definitively in favor of the defendants' doctrinal view. Under its holding, plaintiffs must plead a non-exculpated claim for breach of fiduciary duty against an independent director protected by a 102(b)(7) provision, or that director will be entitled to be dismissed from the suit. That rule applies regardless of the underlying standard of review for the transaction. When a director is protected by an exculpatory provision, a plaintiff can survive a director defendant's motion to dismiss only by pleading facts supporting a rational inference that the director either:

The mere fact, however, that 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 the responsibility to plead a non-exculpated claim against each director who moves for dismissal.

In support of its holding, the Supreme Court emphasized its decision in Malpiede — a case that did not feature prominently in the Court of Chancery's discussion (Malpiede v. Townson, 780 A.2d 1075, 1083-84 (Del. 2001)). In Malpiede, the Supreme Court analyzed the effect of a Section 102(b)(7) provision on a breach of the duty of care claim against directors who approved a transaction that was subject to enhanced scrutiny under Revlon. There the Supreme Court stated that although "plaintiffs are entitled to all reasonable inferences flowing from their pleadings, ... if those inferences do not support a valid legal claim, the complaint should be dismissed" (780 A.2d at 1094). Because an exculpated director will only be liable for monetary damages if he has breached a non-exculpated duty, a plaintiff who pleads only a due care claim against that director has not set forth any grounds for relief. In such a case, the Malpiede Court said that Section 102(b)(7) would bar the claim. (Conceivably, the Malpiede decision did generate significant discussion in the lower court decision because it involved the enhanced scrutiny standard of review rather than entire fairness. The inferences about directors that the plaintiffs in Cornerstone argued should be found in controller transactions, where entire fairness is invoked, may not be as pronounced in transactions governed by Revlon.)

The Supreme Court here also cited Malpiede for its discussion of the legislative rationale for Section 102(b)(7), which was adopted after the Smith v. Van Gorkum decision (488 A.2d 858 (Del. 1985)). Van Gorkum had triggered a fear among directors that they could face personal liability for pursuing potentially value-maximizing business decisions in good faith. To guard against that disincentive, the Delaware General Assembly passed Section 102(b)(7) to protect directors against allegations of breaches of the duty of care and thereby "free[] up directors to take business risks without worrying about negligence lawsuits" (Malpiede, 780 A.2d at 1095). This rationale, the Supreme Court explained here, applies equally to the issue at hand. Delaware law recognizes that the negotiating efforts of independent directors can help to secure transactions with controlling stockholders that are favorable to the minority. Establishing a rule that all directors must remain as parties in litigation involving a transaction with a controlling stockholder would undermine that benefit and reduce the benefits that were anticipated in adopting Section 102(b)(7).

The Supreme Court also emphasized the core tenet under Delaware law that independent directors are presumed to be motivated to do their duty faithfully. For that reason, the mere fact that a director serves on the board of a corporation with a controlling stockholder does not automatically make that director not independent (Aronson v. Lewis, 473 A.2d 805, 815 (Del. 1984)). In addition, as stated in Southern Peru, Delaware law presumes that an independent director is entitled to the protection of the business judgment rule, even though the controlling stockholder may itself be subject to liability for breach of the duty of loyalty if the transaction was not entirely fair to the minority stockholders (S. Peru, 52 A.3d at 785). To require independent directors to remain defendants solely because the plaintiffs stated a non-exculpated claim against only the controller and its affiliates would be inconsistent with these principles.

The Supreme Court lastly turned to its apparently conflicting ruling in Emerald Partners II. The Supreme Court here distinguished that decision on the basis that the plaintiffs in that case pled facts that would support the inference not only that each director had breached his duty of care, but also his duty of loyalty. There the Supreme Court held that the determination of whether any failure of the putatively independent directors was the result of disloyalty (which is not exculpated) or a lapse in care (which is) would be best determined after a trial, because the substantive-fairness inquiry would shed light on why the directors acted as they did. However, the Supreme Court here explained that that is only a relevant consideration when facts that could support a claim for a breach of the duty of loyalty have been pled, and the sentence in Emerald Partners II that would appear to be dispositive in the plaintiffs' favor here must be understood in that context. The Supreme Court added a blanket statement that if there "other isolated statements" in the Emerald Partners decisions that could be interpreted as inconsistent with the decision here, the Emerald Partners decisions should be read in their case-specific context and not for the broad proposition that the plaintiffs advocated.

The Supreme Court's decision resolves an issue that had vexed many directors and their counsel since the Court of Chancery's decision in Cornerstone. The lower court ruling had raised the same substantive arguments made in the Supreme Court's decision for why independent directors should be able to obtain dismissal of non-particularized claims, including the warning that a ruling in the plaintiffs' favor would create a disincentive for independent directors to negotiate transactions with controlling stockholders. The Supreme Court has now removed that disincentive and aligned the law on the subject with the doctrinal presumption of loyalty on the part of independent directors.

The decision also reduces the urgency that controlling-stockholder transactions be structured to satisfy M&F Worldwide. Although it is always preferable for boards to operate with the benefit of the business judgment rule, the fact that a transaction will be reviewed for its entire fairness will no longer mean that the independent directors will by necessity be involved in the litigation until its conclusion.