Delaware Court of Chancery Addresses the “Cleansing Effect” of Stockholder Approval In Post-Closing M&A Damages Actions
In two recent decisions, City of Miami General Employees’ & Sanitation Employees’ Retirement Trust v. Comstock, C.A. No. 9980-CB, 2016 Del. Ch. LEXIS 133 (Del. Ch. Aug. 24, 2016) (Bouchard, C.) (“Comstock”), and Larkin v. Shah, C.A. No. 10918-VCS, 2016 Del. Ch. LEXIS 134 (Del. Ch. Aug. 25, 2016) (Slights, V.C.), the Delaware Court of Chancery addressed the salutary effect of stockholder approval on the standard of review to be applied when evaluating damages claims in post-closing merger litigation. The Delaware Supreme Court first recognized this effect in Corwin v. KKR Financial Holdings, LLC, 125 A.3d 304, 309 (Del. 2015), holding that “[w]hen a transaction not subject to the entire fairness standard is approved by a fully informed, uncoerced vote of the disinterested stockholders, the business judgment rule applies.” But, since Corwin, the precise meaning of the phrase “not subject to the entire fairness standard” — and thus the scope of Corwin’s holding — had not been addressed. Comstock and Larkin do so, with Larkin extending Corwin’s holding the furthest. Larkin declares that fully informed, uncoerced stockholder approval changes the standard of review in post-closing litigation to the more deferential business judgment rule in all instances save one: when the presence of a controlling stockholder triggers entire fairness review, in which case the entire fairness standard remains applicable.
In Comstock, plaintiff pursued, post-closing, a putative class action challenging C&J Energy Services, Inc.’s merger with a subsidiary of Nabors Industries, Ltd. Plaintiff alleged, among other things, that C&J’s board members and certain officers breached fiduciary duties. Defendants moved to dismiss.
Chancellor Bouchard first disposed of plaintiff’s disclosure claims. After doing so, he turned to the plaintiff’s process and price claims — claims ordinarily subject to enhanced scrutiny, Delaware’s searching intermediate standard of review. Starting, however, with the premise that C&J’s stockholders were fully informed at the time they approved the merger, he determined that the business judgment rule would apply under Corwin “unless plaintiff [could] establish a basis for applying entire fairness.” The complaint advanced two bases to justify entire fairness review: (1) a majority of the C&J board was interested in the transaction; and (2) C&J’s CEO fraudulently tainted the process by which the board considered the transaction. But Chancellor Bouchard found that the complaint contained insufficient supporting facts and thus did not escalate the standard of review to entire fairness. As a result, the business judgment rule applied and required dismissal because the only claim viable under the business judgment standard was one attacking the merger on grounds of waste, a claim not pled.
Comstock, in applying Corwin, appears to accept at face value and without qualification the phrase “not subject to the entire fairness standard.” Its analytical approach suggests that stockholder approval of a merger will not change the standard of review to the business judgment rule if entire fairness review otherwise applies for any reason, including when a majority of the board is interested or lacks independence, or when a corporate fiduciary fraudulently taints the board’s decision-making process.
In Larkin, Vice Chancellor Slights applied the cleansing effect recognized in Corwin more broadly. There, plaintiffs brought a putative class action complaint challenging the sale of Auspex Pharmaceuticals, Inc. to Teva Pharmaceuticals Industries, Inc. Plaintiffs alleged that certain members of the Auspex board, including the leader of Auspex’s negotiation team, had ties to venture capital firms owning a significant percentage of Auspex’s common stock. Plaintiff alleged that these firms jointly asserted their control to prematurely conclude the sale process to satisfy their own liquidity needs. Plaintiffs also alleged that a majority of directors suffered disabling conflicts of interest. The defendants moved to dismiss.
Vice Chancellor Slights, applying Corwin, held that the only transactions subject to entire fairness review which cannot be “cleansed” by a fully informed stockholder vote are those involving a controlling stockholder. The court explained that coercion is inherently present in votes involving a controlling stockholder, but not where concerns regarding a transaction arise only from board-level conflicts or lapses of due care. Accordingly, even though a majority of the Auspex board were allegedly conflicted (an allegation that, if well pled, invokes entire fairness review), the alleged conflicts did not bear on the inquiry. He then found that (1) there was no controlling stockholder in Larkin, (2) that even if there had been a controlling shareholder, plaintiffs had not established the purported controller had engaged in a conflicted transaction, and (3) the disinterested stockholders’ decision to tender their shares was fully informed and not coerced. As a result, the court held that the application of the business judgment rule, in this instance, was “irrebutable” and dismissed the complaint, noting that waste is the only claim available to plaintiffs where the irrebutable business judgment rule applies.
Both Comstock and Larkin demonstrate the important effect that stockholder approval has on the standard of review. Larkin, more than Comstock, seems to align with the rationale undergirding the deference Delaware courts traditionally afford stockholder-approved transactions. See J. Travis Laster, The Effect of Stockholder Approval on Enhanced Scrutiny, 40 Wm. Mitchell L. Rev. 1443 (2014) (“Delaware law searches for an independent, disinterested, and sufficiently informed decision maker. If one exists, then the court defers to the decision that the qualified decision maker made.”). As a corollary, only when the corporation’s stockholders are compromised as a decision maker (such as when there is a controller transaction and minority stockholders face a threat of implicit coercion) should their decision not warrant deference. Allegations of an insufficient number of independent and disinterested board members, however, say nothing about the qualifications of the stockholders as a decision maker. Larkin most clearly recognizes this point: A compromised board has no bearing on the cleansing effect that stockholder approval affords.