Delaware Court of Chancery Opines on Bad Faith, Gross Negligence and Banker Liability in "Zale" and "TIBCO"

Practical Law Legal Update w-000-7102 (Approx. 9 pages)

Delaware Court of Chancery Opines on Bad Faith, Gross Negligence and Banker Liability in "Zale" and "TIBCO"

by Practical Law Corporate & Securities

Zale Background

The dispute in Zale arose out of the acquisition of Zale Corporation by rival jeweler Signet Jewelers Limited. For a summary of the merger agreement, see What's Market, Signet Jewelers Limited/Zale Corporation Merger Agreement Summary. In the run-up to the negotiation of the merger agreement, Zale's largest stockholder, Golden Gate Capital, notified Zale that it intended to sell its shares in a secondary offering. To effectuate the offering, Zale and Golden Gate engaged investment bank Merrill Lynch as lead underwriter.

On October 6, 2013, the CEO of Signet reached out to a Zale director to indicate interest in a potential acquisition of Zale. The next day, Merrill Lynch—while working on the secondary offering and in possession of confidential information regarding Zale—made a presentation to Signet's CEO and CFO to pitch an acquisition of Zale at a value between $17 and $21 per share.

On November 6, 2013, Signet made an offer to buy all of Zale's outstanding shares at a price of $19 per share (the exact midpoint of the range suggested by Merrill Lynch), prompting Zale's board to form a negotiation committee and hire a financial advisor. A team from Merrill Lynch pitched the committee for the assignment and represented that it did not expect its representation of Golden Gate to impact its ability to advise the board. The team included a managing director who was a senior member of the team that had pitched Signet on an acquisition, yet neither he nor Merrill Lynch disclosed to the Zale board committee that it had made that pitch. On the contrary, Merrill Lynch represented that it had "limited prior relationships and no conflicts with Signet," which the board essentially accepted without further inquiry and without interviewing any other candidates for financial advisor. Merrill Lynch only disclosed to the Zale board during the preparation of the proxy statement, after the merger agreement had already been signed, that it had pitched Signet on a deal for Zale.

The negotiations between Zale and Signet eventually resulted in an agreement for an acquisition at $21 per share (the top of the range provided to Signet by Merrill Lynch) and with customary deal-protection measures in the merger agreement. The deal proved somewhat divisive among Zale's stockholder base and the proxy advisory services ISS and Glass Lewis, and the disclosure of Merrill Lynch's previous pitch to Signet was seized by opponents of the deal as proof that the sale price had been held down by Merrill Lynch to save face. However, the merger was ultimately approved by a majority of the stockholders.

The plaintiff stockholders' complaint included three counts, alleging that the board had breached its fiduciary duties of care and loyalty by failing to act in good faith and on an informed basis, and that both Signet and Merrill Lynch had aided and abetted in those breaches. The defendants filed a motion to dismiss, countering that the director defendants could not be held liable because the 102(b)(7) provision in Zale's charter exculpates them for breaches of the duty of care, and they had not acted in bad faith so as to be found in breach of the duty of loyalty. Signet and Merrill Lynch, in turn, could not be held liable, either because there was no underlying breach that they aided and abetted, or alternatively, that they had not knowingly participated in any breach.

TIBCO Background

The decision in In re TIBCO Software Stockholders Litigation, (Del. Ch. Oct. 20, 2015), was the second decision to be rendered by the court in this litigation. The court had previously ruled against the plaintiffs, who had sought a preliminary injunction (PI) to enjoin the closing of the acquisition of TIBCO Software Inc. by private equity buyer Vista Equity Partners (see the What's Market merger agreement summary). The decision on the PI, including the factual background, are summarized in Legal Update, In re TIBCO: Court of Chancery Declines to Reform Merger Terms or Enjoin Vote Due to Share-Count Error. In brief, the consideration for the transaction between Vista and TIBCO was negotiated on the basis of a mistaken capitalization table prepared by TIBCO's financial advisor Goldman Sachs. Because of a double counting of 4.3 million restricted shares, the parties assumed that the equity value of the transaction was $4.244 billion, when in actuality it was $100 million lower. However, the merger agreement itself never provided an equity value, instead only providing the per-share price of $24 and the correct capitalization in the capitalization representation. The joint press release for the transaction announced the mistaken values, while the error was only discovered during the preparation of the proxy statement. On learning from Goldman Sachs of the error, the TIBCO board did not ask Goldman how the error had happened, whose fault it was, whether Vista had been aware of the error all along or whether Vista would be willing to pay some or all of the $100 million that everyone had assumed it would be paying all along. For its part, Goldman Sachs did not volunteer this information to the board, even though it knew—because Vista admitted so to it—that Vista had relied on the faulty share count in formulating its bid. The board ultimately decided not to reopen negotiations with Vista, fearing that that request could reopen the entire agreement. Goldman Sachs reaffirmed its fairness opinion and the stockholders approved the transaction.

The plaintiff stockholders sued, arguing for reformation of the contract because of the error to require Vista to pay the remaining $100 million. The plaintiffs also alleged a breach of fiduciary duty by the board, arguing that the directors had breached their duties by failing to correct, or even approach Vista to discuss correcting, the error once it was discovered, and by failing to adequately inform themselves after the discovery. The plaintiffs also asserted a count of aiding and abetting in that breach against Goldman Sachs, along with counts of unjust enrichment and professional malpractice.

Revlon Standard of Review, with Reservation for Possibility of Business Judgment

As a preliminary matter, the court had to determine whether the conduct of the defendant directors was reviewable under the enhanced scrutiny standard of review, in which, under Revlon, the board's efforts at maximizing the sale price are reviewed for reasonableness, or whether the directors were entitled to the presumptions of the business judgment rule. The TIBCO decision essentially assumed that reasonableness was the appropriate standard, but the Zale decision explicitly grappled with the fact that the Court of Chancery had ruled in KKR that even in the sale context, the standard of review reverts to business judgment if a fully informed vote of a majority of the disinterested stockholders approve the transaction. The court added that the Delaware Supreme Court had heard the appeal on September 16, but as of the decision in Zale, had yet to render its verdict. In that vein, the Zale court analyzed the efficacy of the stockholder vote, finding that it was fully informed and rendered by a disinterested majority. (The court addressed the plaintiffs' argument that Golden Gate, as a 23.3% stockholder, should not have been considered disinterested because it had an ulterior motive of seeking liquidity for its stake. The court dismissed this argument, primarily on the basis that Golden Gate had the secondary offering through which it could achieve liquidity.) However, because the Zale court did not yet have the benefit of the Delaware Supreme Court's decision in KKR (see Legal Update, Delaware Supreme Court Affirms "KKR," Lowers Standard of Review from Enhanced Scrutiny to Business Judgment when Merger Approved by Fully Informed Stockholder Vote), it decided to analyze the defendants' conduct under a standard of reasonableness.

As the Zale and TIBCO courts explained, the analysis of the directors' conduct under Revlon's reasonableness test overlaps as a practical matter with the directors' right to exculpation via a 102(b)(7) charter provision. In that instance, liability for the directors can only be premised on a nonexculpated claim, which is predicated on a breach of the duty of loyalty, including bad faith conduct. To establish such a claim, the plaintiffs must show either that:

A majority of the board was not both disinterested in the transaction and independent. Disinterest is undermined if the directors will receive a personal benefit not shared equally by the other stockholders, while independence means that a director's decision is not based on extraneous considerations or influences like a director's or stockholder's control. In either case, the disqualifying self-interest or lack of independence must be material (for a recent example of this issue, see Legal Update, Delaware Supreme Court Reverses Chancery Court in "Sanchez Energy," Finds Reasonable Doubt of Director Independence).
The directors, though a majority of whom were disinterested and independent, acted in bad faith, as when a director "intentionally fails to act in the face of a known duty to act, demonstrating a conscious disregard for his duties" (Lyondell Chem. Co. v. Ryan, 970 A.2d 235, 243 (Del. 2009), quoting In re Walt Disney Co. Deriv. Litig., 906 A.2d 27, 67 (Del. 2006)). In the context of a sale, the plaintiffs would therefore have to demonstrate that the directors "utterly failed to attempt to obtain the best price" (Lyondell at 244).
The decision, though rendered by a disinterested and independent board, was so far beyond the bounds of reasonable judgment that it can only be explained by bad faith (see In re Novell, Inc., S'holder Litig., , at *10 (Del. Ch. Jan. 13, 2013)).

The plaintiffs in TIBCO conceded that the board was disinterested and independent. In Zale, the plaintiffs alleged that four of the board's nine members were conflicted in some fashion and had controlled the sale process. However, the court, following its decision in OPENLANE, held that a conflicted director could still participate in the sale process as long as the board was aware of the conflict and "fully committed to the [sale] process" (In re OPENLANE, Inc. S'holder Litig., , at *5 (Del. Ch. Sept. 30, 2011)). The court added that the alleged conflicts did not appear to be material in any event, and that, for example, early vesting of stock options in a merger does not necessarily create a conflict between directors and stockholders (and can in fact further align their interests).

Allegations of Bad Faith Dismissed

With no reasonably conceivable grounds for finding self-interest or lack of independence, the court in both Zale and TIBCO analyzed the directors' conduct for bad faith and found nothing to support such an allegation. Highlights of the two rulings on this issue include the following:

The assurance from Merrill Lynch to the Zale board that it had no conflict, and the three meetings the board held to discuss the matter after learning of Merrill Lynch's prior pitch to Signet, were enough to avoid a finding of conscious disregard of the directors' duties.
The Zale board's decision to forego a market check was arrived at after the board weighed the possibility that word of a deal with Signet would leak. This was enough to rebut an allegation of bad faith.
The fact that two large stockholders and Glass Lewis opposed the merger did not mean that the $21 per share price was inexplicable on any grounds other than bad faith, as another large stockholder, as well as ISS, supported the deal.
The deal was not impermissibly locked up by virtue of the deal-protection measures and a voting agreement with Golden Gate, because Golden Gate's interests were aligned with the other stockholders and the remaining measures were customary. The court added that the fact that Signet's reverse break-up fee was double the size of Zale's break-up fee, and that the board negotiated a fiduciary out that was exercisable during a three-month period between signing and closing, were indicators of good faith on the part of the board.
The TIBCO board did not act in bad faith by foregoing the option of approaching Vista to renegotiate the price, because that overture carried the risk that Vista would repudiate the $24 per share price altogether.
Although the allegation that the TIBCO board had not sought enough information from Goldman Sachs after learning of the error was "troubling," the fact that the board met twice after the discovery to discuss the error and assess its options was enough to satisfy the low bar articulated in Lyondell.

The practical implication of these findings is that any credible amount of discussion by the board of a given issue is frequently enough to avoid a finding of bad faith on that issue. Boards should therefore be scrupulous about documenting their discussions of critical deal points, as that documentation can prove enough to defeat an allegation of bad faith. In any event, in light of the Delaware Supreme Court's decision in KKR, the board should emphasize fulsome disclosure to the stockholders, as a fully informed vote restores the presumptions of the business judgment rule.

Allegations that Support a Potential Finding of Breach of the Duty of Care

Although the boards of both Zale and TIBCO were exculpated for breaches of the duty of care, the court still analyzed whether an underlying breach had been committed, as that breach could still form the foundation for a finding of aiding and abetting. In each case, the court found that, for purposes of ruling on a motion to dismiss and therefore drawing all reasonable inferences in the plaintiffs' favor, a breach of the duty of care was reasonably conceivable. In particular, the court held:

In TIBCO, that there was a "wide gulf" between what the board did on learning of the error and what one would rationally expect a board in that situation to do. The court explained that the board should have pressed Goldman Sachs for a complete explanation concerning the circumstances of the error. That complete picture, which the board did not have, would have helped it make its decision over how or if to approach Vista. The board's decision itself, the court said, would still be a matter of business judgment, but the failure to make basic inquiries could conceivably rise to the level of gross negligence, which is the standard for finding a breach of the duty of care. (The court noted again for clarification that even failing to meet the standard of gross negligence does not mean that the board must have acted in bad faith.)
In Zale, that it was reasonably conceivable that the board did not act in an informed manner on learning of Merrill Lynch's prior pitch. The court acknowledged that the board at least generally considered Merrill Lynch's potential conflicts and relied on its representation, but held that these facts alone were not enough at a preliminary stage to dismiss an allegation of breach of the duty of care. The court outlined what, instead, the board of Zale might reasonably have done throughout the process, such as:
- negotiating representations and warranties in the engagement letter with Merrill Lynch;
- asking "probing questions" to determine what prior interactions its advisor had with known potential buyers;
- asking, in particular, whether the potential advisor had made any presentations regarding Zale to prospective buyers within, for example, the last six months, or since taking on the representation of Zale in the secondary offering; or
- considering other candidates for the engagement.

Reasonable Conceivability of Aiding and Abetting

In light of its findings in Zale and TIBCO that the respective boards had potentially breached their duty of care, the court turned to the allegations that the respective financial advisors had aided and abetted those breaches. The elements for a finding of aiding and abetting are the existence of a fiduciary relationship, a breach of the fiduciary's duty, and knowing participation in the breach by the third party. In both Zale and TIBCO, the first two elements had been satisfied, leaving the main focus on the element of knowing participation.

Before turning to the allegation against Merrill Lynch, the Zale court first addressed the plaintiffs' allegation that Signet had also aided and abetted the breach by failing to disclose to Zale that it had recently received a pitch from Merrill Lynch. However, this theory failed on two grounds:

The underlying wrongdoing was not the fact of the pitch itself, but the board's failure to do enough to learn of it from Merrill Lynch. Signet had nothing to do with that breach and could not have knowingly participated in it.
An arm's-length negotiation negates a claim of aiding and abetting, and Signet negotiated at arm's length with Zale.

As for the financial advisors, the court found in both TIBCO and Zale that, for purposes of a motion to dismiss, it was reasonably conceivable that the respective financial advisors had aided and abetted in the boards' breaches of the duty of care. The TIBCO court highlighted the decision in Rural/Metro, which explained that a third party knowingly participates in the board's breach when it misleads the board or creates an "informational vacuum" (In re Rural Metro Corp. S'holder Litig., 88 A.3d 54, 97 (Del. Ch. 2014)). In TIBCO, although the board did not ask probing questions of Goldman Sachs, Goldman Sachs itself knew that the board was not gathering enough information to discharge its duty of care. In particular, Goldman Sachs was aware that Vista had relied on the mistaken share count to formulate its bid, but did not proactively disclose that information to the board of TIBCO precisely when the board needed that information. That failure to disclose was precisely what the court had in mind when it articulated the "informational vacuum" standard. The court also credited the plaintiffs' theory that Goldman Sachs did not disclose what it knew because it was motivated by its desire to preserve its fee, of which 99% was contingent on the closing.

In Zale, the court found that for purposes of a motion to dismiss, Merrill Lynch could be found to have knowingly participated in the breach. Merrill Lynch's prior pitch to Signet was directly connected to the underlying breach by the Zale board, because Merrill Lynch (unlike Signet) was in a position to disclose what it knew to the board. The court also found that the breach did potentially result in damages to the stockholders, for several reasons:

The time and money spent negotiating with a conflicted advisor could have constituted damage to Zale.
Hiring a second, unconflicted advisor would cost an additional fee.
If the board were to decide to exercise its fiduciary out rather than close, it would have to pay the break-up fee.

These same reasons formed the basis for the Zale court's conclusion that the conflict could not be cleansed through disclosure to the stockholders, because the damage had already been done.

Practical Implications of Potential Aiding and Abetting Liability in Zale

The Zale decision has been met with some surprise for its widening of the scope of potential liability for financial advisors. Whereas previous decisions such as Rural/Metro, Del Monte and El Paso had understandably found fault among banks who acted on both sides of the deal, the Zale decision apparently represents a new level, in which the common business practice of pitching companies for business can come back to form the grounds for liability. However, it should be noted that the decision in Zale relies on several factual and legal findings, all of which appear critical to the court's ruling and which investment banks (and target companies, for matters in their control) can take action to avoid:

The team that pitched Signet and the team that ultimately advised Zale included the same senior member. To avoid the appearance of conflict, banks should record the members of the team that pitches any given company on an acquisition and substitute its senior members on any team that ultimately wins business with the proposed target company.
The pitch to Signet and the engagement with Zale were separated by mere weeks. A longer period of time may be enough to negate the concern of conflict.
Merrill Lynch pitched Signet while working on a secondary offering for Zale and in possession of confidential information concerning Zale. Although Merrill Lynch insisted that it did not use that information for its pitch, this confluence of circumstances does not come with strong optics.
Zale did not negotiate representations and warranties in its engagement letter with Merrill Lynch concerning Merrill's previous interactions with Signet. A more robust engagement letter could have sufficed for the board to satisfy its duty of care.
The ultimate sale price for Zale was exactly at the high end of the range provided to Signet. Had the valuation range in the presentation to Signet been more general, there may not have been the appearance of a financial advisor deliberately keeping the price from going any higher. Certainly had the final price been higher than the highest price suggested to Signet, the plaintiffs would presumably have had a much harder time establishing aiding and abetting.
The board did not consider any other advisors besides Merrill Lynch.

Other ways to avoid the appearance of impropriety in this situation are to perform a market check, which would help confirm that the price obtained by the buyer was the highest price reasonably available, and to disclose the prior pitch at the very outset of the engagement, before negotiations begin in a potentially compromised state. At an early stage, the board can consider the extent of the conflict and whether it should engage a different, or a second, advisor.

As implied by the decision itself, another important factor in the decision is that the court applied the Revlon standard of review, in spite of the approval of the stockholders. Had the Delaware Supreme Court's decision in KKR been issued before the Court of Chancery's decision in Zale, it is entirely possible that the Zale court would have found that the board's reaction to learning of the prior pitch was more than enough to satisfy the business judgment rule. That said, there are two reasons why practitioners should not be quick to throw out Zale as a relic of the pre-KKR era:

Even under KKR, the Revlon standard still applies up until the stockholders vote to approve the deal. Thus, a plaintiff could file suit to enjoin the merger on the basis of the conflict described in Zale.
In footnote 106 of its decision, the court states that "arguably," the board's actions vis-à-vis Merrill Lynch could even constitute a breach of the duty of care on a standard of gross negligence. Thus, the court intimates that even if free of the heightened Revlon standard, the board's failures here could form the basis for a finding of third-party liability for aiding and abetting.

Delaware Court of Chancery Opines on Bad Faith, Gross Negligence and Banker Liability in "Zale" and "TIBCO" | Practical Law