On September 28 and October 1, 2015, the Delaware Court of Chancery issued decisions in Caspian Select Credit Master Fund Limited v. Gohl, C.A. No. 10244-VCN and In re Zale Corporation Stockholders Litigation, C.A. No. 9388-VCP. On October 2, 2015, the Delaware Supreme Court decided Delaware County Employees Retirement Fund v. Sanchez, No. 702. The outcome for the director defendants in each case differed: the claims against the Zale directors were dismissed, the claims against directors in Caspian largely survived at the pleading stage, and the claims against the directors in Sanchez, where the Chancery Court had granted the defendants’ motion to dismiss, were reinstated when the Supreme Court reversed. These contrasting results largely are attributable to the existence in Zale of an independent board of directors, whereas the pleadings in Caspian and Sanchez sufficiently alleged that a majority of the boards of the companies at issue lacked independence. In addition, the Zale decision underscores again the risks confronting financial advisors to sellers in merger transactions, since the aiding and abetting fiduciary breach claim against the board’s financial advisor survived even though the fiduciary duty claims against the directors themselves were dismissed.
Caspian Background
Key Plastics Corporation, a global supplier of automotive components, emerged from Chapter 11 bankruptcy with two controlling stockholders: Wayzata Opportunities Fund II, L.P. and Wayzata Opportunities Fund Offshore, II, L.P., which together owned 91.5% of Key Plastics’ stock. The Wayzata funds were managed and controlled by Wayzata Investment Partners LLC.
As part of its Chapter 11 reorganization plan in early 2009, Key Plastics obtained a two-year, $25 million loan from Wayzata Opportunities at an interest rate of LIBOR plus 11%. Between 2010 and 2013, the parties modified the loan five times, ultimately increasing the total commitment to nearly $80 million at a minimum interest rate of 20%. Key Plastics’ minority stockholders alleged that the modifications were designed to benefit the Wayzata entities at the minority stockholders’ expense, and that the board hastily agreed to these changes because it was beholden to the Wayzata Funds, including because the Wayzata Funds had appointed a majority of Key Plastics’ directors to the boards of Key Plastics and numerous other companies in which the Funds held a significant stake.
In January 2015, Key Plastics’ minority stockholders brought claims for breach of fiduciary duty against the company’s directors and certain executives, as well as the Wayzata Funds and Wayzata Partners. The defendants jointly sought dismissal of the plaintiffs’ claims on the grounds that they had failed to adequately plead that demand on the board was futile or the elements of a fiduciary duty claim. On September 28, 2015, Vice Chancellor Noble denied the motion to dismiss as to all directors except the one who had not been appointed to the board by the Wayzata Funds.
Caspian Takeaways
- It is critical that a board have the ability to form—and then to follow through on the formation of—a special committee of disinterested and independent directors to evaluate any transaction with a controlling stockholder. Vice Chancellor Noble excused the demand requirement ordinarily imposed upon plaintiffs asserting derivative claims under Chancery Court Rule 23.1 because there was reason to doubt the independence of a majority of Key Plastics’ board, and no special committee of independent directors was formed to address that conflict. (It also is unclear whether the Key Plastics board could have formed an independent committee, since only one board member was not beholden to the controlling entities and Delaware courts disfavor one-person committees. See Gesoff v. IIC Indus., Inc., 902 A.2d 1130, 1146 n.101 (Del. Ch. 2006).) Key Plastics’ CEO, who was also a member of the board, had been appointed to his position by the Wayzata Funds. The Wayzata Funds had also appointed three other members of Key Plastics’ five-member board, including one director who was a principal of Wayzata Partners and one who was the CEO of a consulting firm that obtained substantial revenues from Wayzata Partners. Both had also been appointed by Wayzata to the boards of numerous other companies in which the Wayzata Funds held a significant stake.
- Directors will find it difficult to satisfy a burden of proving the “entire fairness” of a controlling stockholder transaction not approved by independent directors where the board does not retain independent legal and financial advisors or obtain an independent fairness opinion. Vice Chancellor Noble found that the plaintiffs had adequately alleged that the Wayzata Funds (who owed fiduciary duties to Key Plastics’ minority stockholders given their combined 91.5% stake in the company) and the Wayzata-appointed directors breached their fiduciary duties of loyalty. Applying “entire fairness” review, Vice Chancellor Noble concluded that the plaintiffs had adequately alleged that the amendments to the Wayzata loan were not entirely fair. As a matter of price, plaintiffs alleged that comparable companies had obtained unsecured financing at 50-80% lower interest rates and secured financing at 75-90% lower rates, and that seven companies expressed interest in refinancing the company’s debt. As far as process, the court found it significant that the board never obtained an independent fairness opinion or considered alternative sources of financing. However, Vice Chancellor Noble dismissed the plaintiffs’ claims against Key Plastics’ fifth director and its CFO, neither of whom had been appointed by the Wayzata entities, because the plaintiffs had failed to allege that either of those defendants acted in bad faith.
- By exercising control over a controlling stockholder, an entity may be found to owe fiduciary duties to minority stockholders of companies in which it does not actually own stock. Vice Chancellor Noble found that the plaintiffs had stated a breach of loyalty claim against Wayzata Partners, even though Wayzata Partners was not itself a Key Plastics stockholder. The court cited In re Primedia Inc. Derivative Litigation, 910 A.2d 248 (Del. Ch. 2006), where Vice Chancellor Lamb held that private equity firm KKR owed fiduciary duties to Primedia’s stockholders by virtue of its control of entities holding 60% of Primedia’s stock. Here, plaintiffs pled that Wayzata Partners made all decisions for the Wayzata Funds, hand-picked officers of Key Plastics, and dominated the Key Plastics board. As a result, Vice Chancellor Noble concluded that it was reasonable to infer at the motion to dismiss stage that Wayzata Partners exercised control over Key Plastics and used that control to its benefit.
- A Section 102(b)(7) charter exculpation provision will not warrant dismissal of the complaint in most situations where non-independent directors approve a transaction subject to shareholder challenge. In In re Cornerstone Therapeutics, Inc. Shareholder Litigation, 115 A.3d 1173 (Del. 2015), which we previously discussed, the Delaware Supreme Court held that duty of care claims against independent and disinterested directors must be dismissed at the pleading stage pursuant to a Section 102(b)(7) charter provision (notwithstanding “entire fairness” review of controlling stockholder transactions) where the complaint fails to plead facts supporting an inference that the directors breached their duty of loyalty or acted in bad faith. Although Key Plastics’ certificate of incorporation included a Section 102(b)(7) provision exculpating its directors from monetary liability for breach of the duty of care, Vice Chancellor Noble held that Cornerstone did not apply and the charter provision did not offer protection to the conflicted directors because the plaintiffs had adequately alleged that those directors breached their duty of loyalty by favoring the Wayzata entities’ interests over those of Key Plastics’ minority stockholders. Vice Chancellor Noble did find that Key Plastics’ 102(b)(7) provision required dismissal of the duty of care claim against the sole director who had not been appointed by the Wayzata Funds because there was no suggestion that that director was beholden to Wayzata or breached his duty of loyalty.
Zale Background
In 2010, still reeling from the effects of the 2008 financial crisis, Zale Corporation implemented a turnaround strategy focused on improving its standalone prospects, which ultimately returned the company to profitability in 2013. On November 7, 2013, Signet Jewelers made an all cash offer to acquire Zale at $19 per share. In response, Zale’s nine-person board (which consisted of eight non-management directors) formed a Negotiation Committee consisting of four non-management directors, which then considered potential financial advisors. The company had previously been advised by its largest stockholder, Golden Gate Capital (23%), that a particular financial advisor (the “Financial Advisor”) was working as lead underwriter on a secondary offering of stock owned by Golden Gate, and the Negotiation Committee resolved to retain the Financial Advisor on the possible Signet deal if there were no conflicts. (Golden Gate, which also had a $150 million loan outstanding to Zale, canceled the offering upon receiving Signet’s expression of interest.) The board received a presentation from the Financial Advisor on November 11, 2013, in which it stated that it had only limited prior relationships with Signet and no conflicts that would prevent it from advising Zale. The Committee thereafter recommended that the board retain the Financial Advisor, which it did. In fact, however, the Financial Advisor failed to disclose that it earned approximately $2 million from Signet from 2012-2013 and, more importantly, made a presentation only a month earlier to Signet’s management regarding a possible acquisition of Zale in the range of $17 to $21 per share. A senior member of the Financial Advisor’s team retained by the board was part of the Signet presentation.
Ultimately, after several months of negotiations, the parties announced that they had agreed to a merger whereby Signet would acquire Zale for $21 cash per share. After that announcement, several of Zale’s larger shareholders spoke out against the deal, including on the ground that the Financial Advisor’s prior involvement with Signet (which the Zale board did not learn of until March 2014, after the merger agreement was signed) tainted the sales process. Nonetheless, the merger was approved by a majority (53.1%) of Zale’s disinterested stockholders in May 2014. In September 2014, Zale stockholders filed suit, asserting claims against Zale’s directors for breach of fiduciary duty and against Signet and the Financial Advisor for aiding and abetting breach of fiduciary duty.
Vice Chancellor Parsons dismissed all claims except for the plaintiffs’ claim against the Financial Advisor. In dismissing the claims against the Zale directors, Vice Chancellor Parsons ruled that, in an all-cash merger, “Revlon enhanced scrutiny applies, even after the merger has been approved by a fully informed, disinterested majority of stockholders.” Only one day later, however, the Delaware Supreme Court ruled differently in a separate case and held that the business judgment rule is the appropriate standard of review when a merger that is not subject to “entire fairness” review has been approved by a fully informed, uncoerced majority of disinterested stockholders. See Corwin v. KKR Financial Holdings LLC, No. 629, 2014 slip op. (Del. Oct. 2, 2015). Notwithstanding that decision, certain aspects of the court’s opinion in Zale are important independent of the standard of review employed by the court.
Zale Takeaways
- Courts will likely find it to be a breach of the board’s duty of care (even if no monetary liability attaches in light of a Section 102(b)(7) charter provision) where it relies unquestioningly on its financial advisor’s representations as to a lack of conflict without further investigation. Vice Chancellor Parsons held that the Zale board’s duty of care included a duty to detect preexisting conflicts when engaging a financial advisor, including by negotiating for representations and warranties in an engagement letter and asking probing questions about the advisor’s past work for the counterparty to the transaction and other potential buyers. Emphasizing Vice Chancellor Laster’s observation in In re Rural Metro Corp., 88 A.3d 54, 90 (Del. Ch. 2014) that “part of proactive and direct oversight is acting reasonably to learn about actual and potential conflicts faced by directors, management, and their advisors,” Vice Chancellor Parsons criticized the Zale board’s conflict detection measures, as alleged in the complaint, which “consisted simply of discussing the possibility that [the Financial Advisor] would be conflicted and apparently relying without question on [the Financial Advisor’s] representations” as to a lack of material conflict.
- Even if directors are exculpated from monetary liability, a conflicted financial advisor may still be monetarily liable for aiding and abetting the directors’ breach of the duty of care. Vice Chancellor Parsons explained that the Zale directors likely breached their duty of care in failing to detect the Financial Advisor’s conflict based on its prior work for Signet, but that they nonetheless were exculpated from liability pursuant to Zale’s Section 102(b)(7) charter provision. However, Vice Chancellor Parsons upheld an aiding and abetting claim against the Financial Advisor because it allegedly knowingly failed to disclose to the Zale board its presentation to and receipt of fees from Signet. In light of Zale and Rural Metro, financial advisors and their counsel need to have in place procedures for detecting potential conflicts or the appearance of a conflict, and to disclose any conflicts that are found, when seeking engagements in M&A and other transactions. Delaware courts will be particularly critical of undisclosed attempts to work for potential buyers in the transaction at issue, as the Financial Advisor in Zale sought to do.
- Once a court concludes that a duty of care claim is pled against directors, the threshold for pleading that a financial advisor aided and abetted the board’s fiduciary duty breach is not high. Having found that the plaintiffs had adequately pled a breach of the duty of care against Zale’s directors, Vice Chancellor Parsons concluded that the plaintiffs had also adequately alleged the Financial Advisor’s participation in that breach because “it was [the Financial Advisor’s] decision to delay disclosure of [its] conflict until [after the merger agreement was signed] that caused [the court] to find that the Director Defendants’ breach of their duty of care conceivably caused damage to stockholders.” Vice Chancellor Parsons added that, on the truncated record before him, he could only speculate as to why the Financial Advisor’s presentation to Signet did not come up in connection with the Zale board’s decision to make a counter-offer of $21 per share in response to Signet’s offer of $20.50. At the pleading stage, however, the court found it “reasonably conceivable that [the Financial Advisor’s] undisclosed conflict,” including the fact that it had previously suggested to Signet an acquisition of Zale in the $17-$21/share range, “hampered the ability of [the Financial Advisor] and, consequently, the Board to seek a higher price for Zale’s stockholders.”
- The court found that Golden Gate was not interested in the transaction even though the deal provided liquidity with respect to its 23% stock ownership in Zale and Golden Gate would receive a pre-payment fee on its loan in the amount of approximately $3.2 million upon a change of control. Vice Chancellor Parsons found that the plaintiffs had failed to plead sufficient facts explaining why Golden Gate needed liquidity so severely that its receipt of a pre-payment fee upon consummation of the merger would constitute a unique benefit to Golden Gate not shared by other stockholders. Vice Chancellor Parsons noted that Golden Gate canceled its secondary offering of Zale stock, which belied the plaintiffs’ theory that Golden Gate was “parched for liquidity.” Vice Chancellor Parsons also observed that plaintiffs had failed to allege that the $3.2 million prepayment fee Golden Gate would receive upon a change of control was material to Golden Gate, especially given that Golden Gate’s 23% stake in Zale was worth approximately $225 million at the merger price. (The result is aligned with Vice Chancellor Parson’s decision in In re: Crimson Exploration Inc. Stockholder Litigation, which we previously discussed. In that case, the court likewise concluded that a large stockholder in the company being acquired was not rendered conflicted by allegations that, in connection with the transaction, it would receive a 1% loan prepayment fee and that it entered into a registration rights agreement to facilitate the sale of its stock.)
- The court rejected allegations that the board acted in bad faith in the merger process by failing to conduct a market check, undervaluing Zale’s stock, agreeing to an unreasonable merger price, and relying on a conflicted financial advisor. The court rejected these price and process allegations because, among other things: (i) the board obtained a price increase of $2/share, including by insisting at the end of the process on a $0.50/share increase; (ii) the board considered in at least three meetings but decided, in consultation with the Financial Advisor, not to perform a market check due to the risk of leaks regarding negotiations with Signet and the low likelihood of a superior alternative offer; (iii) the board considered its Financial Advisor’s valuation of Zale under different scenarios, including as a stand-alone entity, but decided that a merger would generate superior value; (iv) the merger price of $21 per share, which was within the Financial Advisor’s valuation ranges, was not “so far beyond the bounds of reasonable judgment that it seems essentially inexplicable on any ground other than bad faith”; and (v) the Negotiation Committee’s insistence that it only retain the Financial Advisor if there were no conflicts and its reliance on the Financial Advisor’s representations that it had no conflicts did not constitute a “conscious disregard of the directors’ duties required to demonstrate bad faith.” The outcome and the court’s reasoning underscore the high threshold that still exists in Delaware to plead bad faith on the part of directors even where a duty of care claim has been alleged.