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Delaware Court of Chancery Reverses Own Decision in "Zale" Following "Corwin, " Dismisses Claim Against Financial Advisor
Practical Law Legal Update w-000-7275 (Approx. 8 pages)
Delaware Court of Chancery Reverses Own Decision in "Zale" Following "Corwin," Dismisses Claim Against Financial Advisor
by Practical Law Corporate & Securities
| Published on 03 Nov 2015 • Delaware |
The Delaware Court of Chancery reversed its own previous decision in Zale in light of the Delaware Supreme Court's decision in Corwin v. KKR and applied the standard of gross negligence to its review of the board's conduct under the business judgment rule.
On October 29, 2015, the Delaware Court of Chancery reversed its own October 1 holding in Zale in which it had rejected a motion to dismiss an allegation that Merrill Lynch, as financial advisor to Zale Corporation, had aided and abetted a breach of the duty of care committed by the Zale board (In re Zale Corp. S'holders Litig., (Del. Ch. Oct. 1, 2015) (Zale I)). In its reversal, the court held that in light of the decision of the Delaware Supreme Court rendered a day later in Corwin v. KKR Financial Holdings, it (the Chancery Court) should have analyzed the board's underlying conduct under the standard of the business judgment rule, not Revlon's standard of enhanced scrutiny as it had in Zale I (In re Zale Corp. S'holders Litig., (Del. Ch. Oct. 29, 2015) (Zale II)). In so ruling, the Chancery Court also took a position on an issue that had been left unclear after Corwin regarding the necessary showing for a breach of the duty of care when business judgment applies instead of enhanced scrutiny. The court held that when the standard of review shifts from enhanced scrutiny to business judgment as a result of a fully informed vote of a disinterested majority of the stockholders, the standard for a finding of fault on the part of the board is gross negligence, not waste.
Background
The Chancery Court predicted the possibility in Zale I that the Delaware Supreme Court would decide in Corwin that the standard of review can shift to business judgment once a fully informed vote of a majority of the disinterested stockholders approve the merger. In deciding Zale I without the benefit of the Supreme Court's Corwin decision, the Chancery Court held that the plaintiffs had demonstrated a reasonable conceivability that the board of Zale, though itself exculpated for breaches of the duty of care, had breached that duty under the Revlon standard of enhanced scrutiny (see Legal Update, Delaware Court of Chancery Opines on Bad Faith, Gross Negligence and Banker Liability in "Zale" and "TIBCO"). The underlying conduct that supported a finding of a possible breach was the board's somewhat lax investigation of its financial advisor Merrill Lynch's ties to Zale's acquiror, Signet Jewelers Limited. Flowing from that finding, the court also held that for purposes of a motion to dismiss, Merrill Lynch could be found to have knowingly participated in the breach, because its prior pitch to Signet was directly connected to the underlying breach by the Zale board.
In determining that it would apply the Revlon standard in spite of the stockholder vote that it found was fully informed, the court in Zale I had acknowledged the Chancery Court's decision in KKR that the business judgment rule should apply when such a vote has been held. The KKR court arrived at that decision in part by interpreting the Supreme Court's 2009 decision in Gantler v. Stephens as addressing only the doctrine of stockholder ratification. The doctrine allows a court to shift the standard of review from entire fairness to business judgment when the stockholders ratify the board's decision in question in a fully informed vote that was not mandated by the DGCL. The KKR court held that Gantler was narrowly focused on ratification and did not mean to exclude the possibility that a fully informed, though legally required, vote could shift the standard of review in Revlon situations from enhanced scrutiny to business judgment.
The Zale I court, by contrast, interpreted Gantler more broadly, effectively standing for the principle that a statutorily required stockholder vote cannot lower the standard of review to business judgment, even when the vote is passed by a fully informed majority of the disinterested stockholders. On the basis of that interpretation, the Zale I court applied the Revlon enhanced scrutiny standard of review to the board's conduct, despite finding that the merger at issue had been approved by the majority of the disinterested stockholders in a fully informed vote.
On October 2, 2015, the day after the Zale I decision, the Delaware Supreme Court issued its opinion in Corwin, affirming the Chancery Court's holding in KKR. In Corwin, the Supreme Court clarified that Gantler was narrowly focused on defining the doctrine of ratification and was not intended to address the standard of review that applies when a transaction is approved by an informed, voluntary vote of disinterested stockholders (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).
Following the Supreme Court's decision in Corwin, Merrill Lynch filed a motion for reargument, contending that the Zale I court should have applied the business judgment rule standard of review because of the cleansing effect of the stockholder vote, as described in KKR. The plaintiffs opposed the motion on the grounds that the stockholders were not disinterested and that their vote was not fully informed, thereby rendering the business judgment standard unavailable regardless of the decision in Corwin.
Outcome
The court granted the motion for reargument and amended its October 1st opinion to dismiss the aiding and abetting claim against Merrill Lynch.
Business Judgment the Appropriate Standard
In light of the Supreme Court's decision in Corwin, the Chancery Court held in Zale II that its interpretation of Gantler had been incorrect, material and outcome-determinative. The court agreed with the defendants that business judgment was the appropriate standard of review and that its decision in Zale I had depended, wrongly, on an application of Revlon.
The court denied the plaintiffs' motion in opposition because their argument amounted to a restatement of their complaints over the stockholder vote, which the court had already rejected in Zale I.
Gross Negligence Standard Applies
Although the Corwin court was clear that a fully informed vote of a majority of disinterested stockholders shifts the standard of review to business judgment, the decision had been somewhat ambiguous about the nature of a claim that a plaintiff must present when the business judgment rule applies in that context. The Zale II court addressed this issue explicitly, describing the two possible formulations for the standard that the plaintiff must satisfy when challenging the director defendants' actions in the merger process under the business judgment rule:
- Because of the cleansing effect of the stockholder vote, the plaintiff must state a claim that the director defendants' actions resulted in waste. A claim of waste requires a showing that the action cannot be attributed to any rational business purpose. As recently discussed in Zuckerberg, the test for waste is extreme and rarely satisfied (see Legal Update, "Facebook": For Ratification, Controlling Stockholders Must Adhere to Formalities Under DGCL).
- The plaintiff must demonstrate that it is reasonably conceivable that the director defendants' actions were grossly negligent. To support an inference of gross negligence, the board's decision has to amount to reckless indifference or a gross abuse of discretion—which, though also a difficult standard to meet, is still easier to satisfy than a claim for waste.
Merrill Lynch argued that a transaction approved by a fully informed stockholder vote, causing the business judgment rule to apply, can only be challenged on grounds of waste. In its argument, Merrill Lynch found support in the Chancery Court's language in KKR, which stated that the vote "insulates the transaction from all attacks other than on the grounds of waste." However, the Zale II court, after reviewing both the Corwin decision and the Chancery Court's decision in TIBCO (a decision issued after Corwin and authored by Chancellor Bouchard, the author of KKR), found more support for the view that the appropriate standard was gross negligence. In particular, the Zale II court emphasized that nowhere in Corwin did it say that a plaintiff would have to state a claim for waste, while the TIBCO decision denied a motion to dismiss on the basis of a finding that it was reasonably conceivable that the directors had breached their duty of care by acting in grossly negligent manner.
The court therefore concluded that the gross negligence standard applies when determining whether the defendant directors breached their duty of care under the business judgment rule where a merger has already been approved by the fully informed disinterested stockholders.
Aiding and Abetting Claim Dismissed
Having decided that the standard for breach of the duty of care was gross negligence, the court reached the question of whether the claim against Merrill Lynch for aiding and abetting should be dismissed because it was not reasonably conceivable that the Zale directors had acted in a grossly negligent manner. The court acknowledged that it itself had mused in a footnote in Zale I (as highlighted in the Legal Update on the decision) that the board's failure to follow up on its discovery of Merrill Lynch's previous pitch to Signet could have amounted to gross negligence. The court also reiterated its opinion that:
- Merrill Lynch's conduct was troubling and only belatedly disclosed to the board.
- The board could have reasonably taken extra steps to protect the stockholders, such as negotiating for representations and warranties in the engagement letter and asking about Merrill Lynch's past interactions with potential buyers.
Nevertheless, the court held that while the board's failure to take those extra steps was sufficient to find a breach of the duty of care under Revlon, it did not rise to the level of gross negligence. In searching for a breach rising to that level, the court looked for "a wide disparity between the process the directors used . . . and [a process] which would have been rational," and that, in the language of Caremark, would indicate a failure to exert "a real effort to be informed and exercise judgment." The Zale II court held that the failures of the Zale board did not rise to that level (unlike, potentially, the TIBCO board's conduct) and that it could therefore find no underlying breach of the duty of care. Consequently, the court held that there was no basis for a finding that Merrill Lynch had aided and abetted any breach.
Practical Implications
Though the reversal in Zale II does not come as a major surprise in light of Corwin, the Zale II decision helpfully clarifies the standard for a breach in a situation in which the heightened-scrutiny standard of review has shifted to business judgment. Because that standard is now confirmed to be gross negligence, Delaware law leaves open the possibility that a board may be found to have breached its fiduciary duties by virtue of its conduct in the merger process—as, for example, has been found in TIBCO for purposes of a motion to dismiss. This underlying standard, in turn, leaves financial advisors vulnerable to a finding of aiding and abetting that breach. Indeed, the Zale II court added pointedly that the plaintiffs had failed to make the argument that the Zale directors' conduct had risen to the level of gross negligence—implying that the court was open to being persuaded that that level had in fact been crossed. Target boards should therefore not take this reversal to mean that the duty to fully examine their financial advisor's potential conflicts stemming from prior pitches has been erased.
The following chart summarizes the recent decisions of the Delaware Court of Chancery and Supreme Court on the issues of shifting the standard of review and the doctrine of ratification.
Decision | Subject Matter | Holding |
Shifting the standard of review in sales of the company | The fully informed vote of a disinterested majority of the stockholders to ratify a board action, even though statutorily required, shifts the standard of review in traditional Revlon situations from enhanced scrutiny to business judgment. | |
Standard for breach when the standard has shifted | To state a claim for breach of the duty of care when the standard of review has shifted to business judgment, the plaintiff must demonstrate gross negligence on the part of the board. The plaintiff does not have to state a claim for waste. | |
Gantler v. Stephens, 965 A.2d 695 (Del. 2009), as clarified by Corwin | Applicability of doctrine of ratification | The fully informed vote of a disinterested majority of the stockholders to ratify a board action, when not statutorily required, shifts the standard of review from entire fairness to business judgment. |
Effectiveness of doctrine of ratification | Ratification can be effected by a formal vote or a written action under Section 228 of the DGCL that references the specific corporate act. An informal action like the submission of an affidavit does not suffice. |