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Delaware Supreme Court: Refines the Standards for Reviewing Board Action That Interferes With Director Elections or Stockholder Voting Rights in Control Contests

On June 28, 2023, the Delaware Supreme Court affirmed a Chancery Court decision finding that the board of a real estate services company had not acted for “inequitable purposes” and had “compelling justifications” for a stock sale, which diluted plaintiff’s 50% ownership interest in the company, broke a director election deadlock, and mooted plaintiff’s petition to appoint a corporate custodian. Coster v. UIP Cos., 300 A.3d 656 (Del. 2023) (Seitz, C.J.). The Supreme Court held that the Chancery Court did not err as a legal matter, and its factual findings were not clearly wrong. As to the proper standard of review for stockholder challenges to board action that interferes with director elections or stockholder voting rights in control contests, the Supreme Court folded the three standards of review in this area into a unified standard.

In her suit seeking to cancel the board’s stock sale, plaintiff alleged that the sale had been effectuated to dilute her voting power in violation of the company co-owner's fiduciary duties. In a post-trial opinion, the Chancery Court upheld the stock sale under the entire fairness standard of review and dismissed the action. In the first appeal, the Supreme Court did not disturb the Court of Chancery’s entire fairness decision but remanded with instructions to review the stock sale under Schnell v. Chris Craft Industries, Inc., 285 A.2d 437 (Del. 1971)[1] and Blasius Industries, Inc. v. Atlas Corp., 564 A.2d 651 (Del. Ch. 1988)[2] because entire fairness “is not a substitute for further equitable review under Schnell or Blasius when the board interferes with director elections.”

On remand, the Chancery Court found that the board had not acted for inequitable purposes under Schnell and had compelling justifications for the stock sale under Blasius (because the custodian appointment would harm the company and the stock sale had been previously planned). Notably, the Chancery Court’s compelling justification analysis largely borrowed from the reasonableness and proportionality test in Unocal Corp. v. Mesa Petroleum Co., 493 A.2d 946 (Del. 1985), for defensive measures adopted by a board in response to a takeover threat. In Unocal, “the Supreme Court used an enhanced standard of review to decide whether the directors had reasonable grounds for believing that a danger to corporate policy and effectiveness existed and that the board’s response was reasonable in relation to the threat posed.”

On appeal from the remand decision, the Supreme Court sought to reconcile Schnell, Blasius and Unocal. The Court explained that “[w]hen a stockholder challenges board action that interferes with the election of directors or a stockholder vote in a contest for corporate control, the board bears the burden of proof.” The Court stated that a court should review whether: (1) “the board faced a threat to an important corporate interest or to the achievement of a significant corporate benefit. The threat must be real and not pretextual, and the board’s motivations must be proper and not selfish or disloyal”; and (2) “the board’s response to the threat was reasonable in relation to the threat posed and was not preclusive or coercive to the stockholder franchise. To guard against unwarranted interference with corporate elections or stockholder votes in contests for corporate control, a board that is properly motivated and has identified a legitimate threat must tailor its response to only what is necessary to counter the threat.”

Delaware Court of Chancery: Denying Dismissal, Court Could Not Conclude That De-SPAC Merger Was the Product of Fair Dealing

On January 4, 2023, the Court of Chancery of Delaware denied dismissal of a putative class action alleging breach of fiduciary duty claims against the sponsor and directors of a SPAC who allegedly undertook a value destructive merger and impaired the public stockholders’ ability to decide whether to redeem or to invest in the post-merger company. Delman v. GigAcquisitions3, 288 A.3d 692 (Del. Ch. 2023) (Will, V.C.). The court determined that it could not conclude that the de-SPAC merger was the product of fair dealing because plaintiff sufficiently pleaded that the proxy contained material misstatements and omitted material, reasonably available information.

Citing In re MultiPlan Shareholders Litigation, 268 A.3d 784 (Del. Ch. 2022)[3] the court determined that entire fairness applied here “due to inherent conflicts between the SPAC’s fiduciaries and public stockholders in the context of a value-decreasing transaction.” In essence, plaintiff alleged that defendants undertook the transaction to obtain “colossal” returns on the sponsor’s investment but that the public stockholders would have been better served by liquidation. Defendants also allegedly provided inadequate disclosures to discourage redemptions and ensure greater deal certainty.

The court rejected defendants’ contention that the proxy contained all material information, explaining that compliance with the duty of disclosure is included within the fair dealing facet of the fairness test under Weinberger v. UOP, 457 A.2d 701 (Del. 1983). The court stated that the public stockholders’ redemption decisions were compromised because defendants failed to disclose the cash per share that the SPAC would invest in the combined company, and made an incomplete disclosure of the value that the SPAC and its non-redeeming stockholders could expect to receive in exchange. The court noted that “[b]oth pieces of information would be essential to a stockholder deciding whether it was preferable to redeem her funds from the trust or to invest them in [the combined company].” The court concluded that “[b]ecause the Proxy allegedly misstated and obfuscated the net cash—and thus the value—underlying [the SPAC’s] shares, public stockholders could not make an informed choice about whether to redeem or invest.”

Plaintiff also alleged that defendants overstated the target’s value. The court noted that the target’s value would be highly relevant to the public stockholders’ investment decisions and concluded that the “lofty projections were not counterbalanced by impartial information.” The court “inferred that the defendants knew (and should have disclosed) or should have known (but failed to investigate)” that the target’s production would be difficult to scale as predicted. Therefore, the court concluded that it was reasonably conceivable that the board deprived the public stockholders of an accurate portrayal of the target’s financial health, and consequently the public stockholders could not fairly decide whether it was preferable to redeem or invest.

Delaware Court of Chancery: Clarifies for the First Time That Corporate Officers, Not Just Directors, Have a Duty of Oversight

On January 26, 2023, the Court of Chancery of Delaware denied dismissal of a derivative action alleging that the defendant former head of human resources for a global fast food company breached his fiduciary duties by: (i) consciously ignoring red flags regarding sexual harassment and misconduct at the company (duty of oversight); and (ii) personally engaging in sexual harassment (duty of loyalty). In re McDonald’s S’holder Derivative Litig., 289 A.3d 343 (Del. Ch. 2023) (Laster, V.C.). Rejecting defendant’s argument that Delaware law does not impose any obligation on officers that are comparable to the duty of oversight for directors established by In re Caremark International Derivative Litigation, 698 A.2d 959 (Del. Ch. 1996), the court announced for the first time that “[t]his decision clarifies that corporate officers owe a duty of oversight.”

Concluding “that oversight liability for officers requires a showing of bad faith[,]” the court explained that “[t]he officer must consciously fail to make a good faith effort to establish information systems, or the officer must consciously ignore red flags.” The court stated that the duty of oversight is context-driven and its application will differ depending on the officer’s role. However, “a particularly egregious red flag might require an officer to say something even if it fell outside the officer’s domain.” The court stated that: “To plead a Red-Flags Claim that will survive a Rule 12(b)(6) motion, a plaintiff must plead facts supporting an inference that the fiduciary knew of evidence of corporate misconduct. The plaintiff also must plead facts supporting an inference that the fiduciary consciously failed to take action in response. The pled facts must support an inference that the failure to take action was sufficiently sustained, systematic, or striking to constitute action in bad faith. A claim that a fiduciary had notice of serious misconduct and simply brushed it off or otherwise failed to investigate states a claim for breach of duty.”

The court found that plaintiffs asserted a red-flags claim because they described that defendant: (i) knew about evidence of sexual misconduct; and (ii) acted in bad faith by consciously disregarding his duty to address the misconduct. The court found that plaintiffs alleged a number of red flags, including coordinated EEOC complaints, employee strikes and Congressional inquiries, indicating for pleading purposes that sexual harassment occurred at the company and supporting a reasonable inference that defendant knew about the red flags. The court observed that defendant was the executive officer with day-to-day responsibility for overseeing the human resources function and promoting a safe and respectful environment, and was thus “supposed to have his ear to the ground and be knowledgeable about the Company’s employees.” As to bad faith, the court explained that Delaware law presumes that directors and officers act in good faith, and a complaint must plead facts sufficient to support an inference of bad faith intent. The court stated that several factors support an inference of scienter, including plaintiffs’ allegations that defendant engaged in multiple acts of sexual harassment and concluded that “[w]hen a corporate officer himself engages in acts of sexual harassment, it is reasonable to infer that the officer consciously ignored red flags about similar behavior by others.”

The court also denied dismissal of plaintiffs’ claim that defendant’s own acts of sexual harassment constituted a breach of the duty of loyalty. The court explained that an alleged harasser acts in bad faith and breaches the duty of loyalty because a harasser engages in sexual harassment for selfish reasons. The court concluded by noting: “Sexual harassment is bad faith conduct. Bad faith conduct is disloyal conduct. Disloyal conduct is actionable.”

Notably, on March 1, 2023, the court issued a Rule 23.1 order dismissing the breach of fiduciary duty claims against defendant because plaintiffs had not made a demand on the company’s board before commencing their lawsuit. The court explained that plaintiffs’ claims against defendant were subject to dismissal unless they could plead demand futility under the three-part test in UFCW Union & Participating Food Industry Employers Tri-State Pension Fund v. Zuckerberg, 262 A.3d 1034 (Del. 2021). Plaintiffs asserted that demand on the board was futile because the board faced a “substantial risk of liability” from plaintiffs’ claims. However—as discussed below—the court dismissed plaintiffs’ claims against the board on March 1, therefore demand on the board was not excused.

Delaware Court of Chancery: Allegations on Board’s Response to Red Flags Fell Short Where Board Took Responsive Action

On March 1, 2023, in the same litigation discussed immediately above, the Delaware Court of Chancery dismissed two breach of fiduciary duty claims against the board of a global fast food company: (i) for failing to take action to address red flags indicating that sexual harassment and misconduct were occurring at the company; and (ii) in connection with various executive employment decisions. In re McDonald’s S’holder Derivative Litig., 291 A.3d 652 (Del. Ch. Mar. 1, 2023) (Laster, V.C.). The court held that plaintiffs failed to state a claim against the board for breach of the duty of oversight under In re Caremark International Inc. Derivative Litigation, 698 A.2d 959 (Del. Ch. 1996), for failing to take action to address red flags indicating that sexual harassment and misconduct were occurring at the company. The court also held that plaintiffs failed to state a claim against the board for breach of fiduciary duty in connection with three executive employment decisions.

The court explained that “[a]lthough they have pled facts supporting an inference that red flags came to the attention of the Director Defendants, they have not alleged facts supporting a reasonable inference that the Director Defendants acted in bad faith in response to those red flags.” The court determined that plaintiffs’ allegations fell short regarding the board’s response to the red flags, noting that at the end of 2018 the board began taking various responsive steps that included, among other things, hiring outside consultants, revising the company’s policies, implementing new training programs, providing new levels of support to franchisees, and setting up an employee hotline.

The court also held that plaintiffs failed to state a claim against the board for breach of fiduciary duty in connection with three executive employment decisions because the business judgment rule protected these decisions to: (i) hire the CEO based on his assurance that a consultant with whom he was in an intimate relationship would be removed from the company’s account, (ii) discipline rather than terminate the head of human resources following a sexual harassment incident, and (iii) terminate the CEO without cause rather than with cause after learning that he had engaged in an inappropriate relationship with an employee. The court determined that plaintiffs failed to plead facts sufficient to rebut any of the business judgment rule’s presumptions, which are that “in making a business decision the directors of a corporation acted on an informed basis, in good faith and in the honest belief that the action taken was in the best interests of the company.” Aronson v. Lewis, 473 A.2d 805 (Del. 1984).