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Delaware Chancery Court: More Detailed Disclosures May Be Required When Directors Propose a Transaction While the Company Is Facing Challenging Circumstances

12.03.18
(Article from Securities Law Alert, November 2018) 

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On November 20, 2018, the Delaware Chancery Court held that stockholder approval of a take-private acquisition that took place while the company was under duress did not warrant application of the business judgment rule standard of review at the pleading stage because plaintiffs adequately alleged that stockholders were not fully informed. In re Tangoe Stockholders Litig., 2018 WL 6074435 (Del. Ch. 2018) (Slights, V.C). The court also found plaintiffs adequately alleged non-exculpated breaches of the duty of loyalty.

The court explained that in order to merit business judgment deference for transactions made during a “regulatory storm,” “the directors must demonstrate that they carefully and thoroughly explained all material aspects of the storm to stockholders—how the company sailed into the storm, how the company has been affected by the storm, what alternative courses the company can take to sail out of the storm and the bases for the board’s recommendation that a sale of the company is the best course.” The court stated that “[e]xtraordinary transactions proposed to stockholders in the midst of extraordinary times must be explained with commensurate care.” The court also underscored that “in trying times, the directors must remain focused on the best interests of stockholders, not their own interests.”

Plaintiffs Alleged Material Disclosure Deficiencies Sufficient to Defeat Application of the Corwin Doctrine at the Pleading Stage

Under Corwin v. KKR Fin. Holdings, 125 A.3d 304 (Del. 2015), the business judgment rule applies to transactions approved by “a fully informed, uncoerced majority of the disinterested stockholders.” In Tangoe, the Delaware Chancery Court explained that in order to defeat application of the Corwin doctrine at the pleading stage, plaintiffs must allege that the disclosures provided by the board in connection with the transaction did not include all material information.

The transaction at issue in Tangoe took place after the company failed to complete a restatement in a timely manner; NASDAQ had delisted the company, and the SEC had threatened the company with deregistration. The Tangoe court found that plaintiffs adequately alleged that shareholder approval of the transaction was not fully informed because defendants failed to provide stockholders with (i) audited financials, and (ii) information concerning the status of the restatement. The court recognized that Delaware law “by no means deems audited financial statements material per se.” However, the court found it “reasonably conceivable that a reasonable stockholder would have deemed audited financials important when deciding whether to approve the [t]ransaction” in view of the allegedly “sporadic and heavily qualified” financial information provided by the board. The court noted that the board allegedly commissioned a quality of earnings report for the acquiror, yet “elected not to disclose that report to the public stockholders.” The company also failed to file several quarterly reports, and did not hold annual stockholders meetings for three years. Given this “information vacuum,” the court found plaintiffs sufficiently alleged that stockholder approval “was not fully informed” because stockholders lacked access to “adequate financial information about the [c]ompany and its value.”

With respect to the status of the restatement, the court rejected defendants’ contention that they had “no duty to make a prediction” as to when the restatement would be finalized. The court found that defendants allegedly knew the restatement was nearing completion, yet “chose not to share this information with the stockholders and, thus, deprived them of the opportunity to consider whether to stay the course and allow the [r]estatement to proceed or whether to sell as the consequences of the unfinished [r]estatement were still unfolding.” The court therefore concluded that the Corwin doctrine did not apply because plaintiffs “adequately pled that the [company’s] stockholders were not fully informed when they approved the [t]ransaction.”

Plaintiffs Adequately Alleged Non-Exculpated Breaches of the Duty of Loyalty

Because of the Section 102(b)(7) exculpatory clause in the company’s certificate of incorporation, plaintiffs could survive a motion to dismiss only by alleging breaches of the duty of loyalty. The court explained that pleading a breach of the duty of loyalty requires allegations of “sufficient facts to support a rational inference that the corporate fiduciary acted out of material self-interest that diverged from the interests of the shareholders.”

Here, SEC rules prohibited defendants from obtaining equity awards under the company’s existing incentive plan while the restatement was pending. Plaintiffs alleged that in order to secure their own compensation, defendants established new incentive awards that would vest in the event of a change in control. Plaintiffs alleged that this new incentive plan motivated defendants to expedite the sale of the company. The court found that the new incentive plan “provided reasonably conceivable material benefits” to the defendants, whose “compensation was comprised primarily of equity awards.” The court recognized that the existing equity awards were “increasingly chimerical as the unfinished [r]estatement wore on.” The court found that the alleged “temporal connection” between defendants’ adoption of the new incentive plan and their “decision to shift course toward an allegedly ill-advised sale of the [c]ompany” suggested defendants were motivated by personal financial interest. The court also found it significant that the board faced the threat of a proxy contest, even though the possibility of a proxy contest, standing alone, does not defeat application of the business judgment rule. The court concluded that plaintiffs adequately pled a claim for breach of the fiduciary duty of loyalty as to each of the defendants, and allowed the case to proceed to discovery.