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(Article from Securities Law Alert, November 2018) 

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On October 16, 2018, the Delaware Chancery Court held that an activist investor aided and abetted a board’s breaches of fiduciary duty in connection with the sale of the company. In re PLX Tech. Stockholders Litig., 2018 WL 5018535 (Del. Ch. 2018) (Laster, V.C.).[1] The trial took place solely against the activist investor; the other parties were either dismissed or settled. At issue were the actions of the activist investor’s board designee, who the court found did not disclose significant information concerning the acquisition to his fellow board members. The court further found that the conduct of the activist investor’s board designee could be attributed to the activist investor because the board designee was a co-managing member of the activist investor and played an important “role in directing and implementing [the activist investor’s] strategy” with respect to the sale of the company. Significantly, the court stated that its holding did “not stand for the proposition that the actions of the director-representative of a stockholder can always be attributed to . . . the stockholder that nominated or appointed him, simply by virtue of the fact of the nomination or appointment.”

The court found that the activist investor had purchased a stake in the company for the specific purpose of engineering a sale of the company. Following a proxy contest, the activist investor placed its co-managing member on the board. The activist investor’s board designee subsequently learned that an acquiror intended to purchase the company and was informed of the price the acquiror was willing to pay. The activist investor’s board designee did not disclose this information to his fellow board members. The acquiror ultimately bid for the company, and the company’s directors quickly recommended that stockholders approve the sale of the company to the acquiror. A majority of the company’s stockholders tendered their shares in the first step of the merger.

The court found that there was a predicate breach of fiduciary duty by the directors by (a) engaging in a sales process without knowing critical information about the tip (though Vice Chancellor Laster noted this information was withheld from them), and (b) issuing the Recommendation Statement without disclosing (i) the information concerning the acquiror’s interest in purchasing the company, (ii) the role of the activist investor’s designee in the sales process, or (iii) a discounted cash flow analysis commissioned by the Special Committee. The court further found that the Recommendation Statement mischaracterized projections that were prepared specifically for the purpose of the acquisition as projections made in the ordinary course of business.

Because the court determined that the stockholders’ approval was not fully informed, the court held that the business judgment rule did not apply to the sales process under Corwin v. KKR Fin. Holdings, 125 A.3d 304 (Del. 2015).[2] The court instead applied enhanced scrutiny, the default standard of review when a company is sold for cash. Under this standard, plaintiffs suing a third party for aiding and abetting a breach of fiduciary duty “bear the burden of proving that the directors’ conduct fell outside the range of reasonableness.” The court explained that “evidence of self-interest” can lead to a finding of unreasonableness.

The court observed that an investor’s large stock holding would normally “undermine any concern about divergent interest.” The court explained that “[w]hen directors or their affiliates own material amounts of common stock, it aligns their interests with other stockholders by giving them a motivation to seek the highest price.” However, the court stated that “particular types of investors may espouse short-term investment strategies and structure their affairs to benefit economically from those strategies, thereby creating a divergent interest in pursuing short-term performance at the expense of long-term wealth.” The court noted that “[i]n particular, activist hedge funds are impatient shareholders, who look for value and want it realized in the near or intermediate term.” Here, the court found that the activist investor and its board designee “had a divergent interest in achieving quick profits by orchestrating a near-term sale” of the company. The court also found that “the incumbent directors deferred to [the activist investor’s board designee] when he sought to position himself to best achieve a sale,” and “permitted [him] to take control of the sale process when it mattered most.” The court concluded that the directors breached their fiduciary duties in connection with the sales process and further held that the activist investor’s board designee knowingly aided and abetted those breaches by “creat[ing] a critical informational gap.”

The court nevertheless ruled in favor of the activist investor because the court found plaintiffs failed to prove damages. While the court determined that the transaction was “flawed from a fiduciary standpoint,” the court concluded that “the sale process was sufficiently reliable” to show that “the plaintiffs received consideration that exceeded the value of the Company on a stand-alone basis” because the board “combined a narrow, pre-signing canvass with a post-signing market check.” The court relied on the Delaware Supreme Court’s decision in Dell v. Magnetar Glob. Event Driven Master Fund, 177 A.3d 1 (Del. 2017), to find that the deal price was a “persuasive source of valuation evidence.”[3] The court determined that the deal price likely exceeded the standalone value of the company because the transaction “involved a combination between two companies operating in the same industry.”