Fried, Frank, Harris, Shriver & Jacobson LLP

04/29/2024 | Press release | Distributed by Public on 04/29/2024 13:41

M&A/PE Quarterly Newsletter, April 2024

M&A/PE Quarterly | April 29, 2024

Table of Contents:

2024 Caremark Developments: Has the Court's Approach Shifted?-Walgreens, Skechers, ProAssurance, Segway, and AmerisourceBergen

Historically, Caremark claims-that is, claims of breach of directors' duties of oversight over key risks facing the company-were among the least likely types of claims to lead to director liability; and the Court of Chancery almost always dismissed such claims at the pleading stage. However, in the past few years, the Caremark cases brought by the plaintiffs' bar have been met with increased receptivity, and the court has found in several cases, at the pleading stage, that it was reasonably conceivable (the Delaware standard to survive a motion to dismiss) that directors or officers may have breached their Caremark duties. Notably, in the most recent Caremark cases, decided in late 2023 and early 2024-Walgreens, Skechers, ProAssurance and Segway (discussed below)-the court has re-emphasized a very high bar to success on Caremark claims.

In our view, however, the facts in these most recent cases arguably were not so egregious as to present a real test of the court's overall approach to Caremark cases-and, as such, there is no indication that the court would be unlikely to find potential Caremark liability in cases involving egregious facts following the occurrence of an extreme corporate trauma. Indeed, in that very context, recently, the Delaware Supreme Court, in AmerisourceBergen (discussed below), overturned the Court of Chancery's pleading-stage dismissal of Caremark claims in connection with that company's role in the national opioid crisis.

Caremark oversight duties. Under Caremark, directors face liability for breach of their oversight duties if, with respect to the key compliance risks facing the company, they have: (i) "utterly failed to implement any reporting or information system or controls" (Prong One); or (ii) "having implemented such a system or controls, consciously failed to monitor or oversee its operations thus disabling themselves from being informed of risks or problems requiring their attention" (Prong Two). Corporate officers also have a duty of oversight under Caremark (as recently established in McDonald's)-which essentially requires that they report "red flags" suggesting improper oversight up the chain of responsibility (particularly with respect to issues within the officer's areas of responsibility, but also possibly issues outside those areas if there is an especially "egregious red flag").

Greater receptivity to Caremark claims in the past few years. Traditionally, the court has stressed that "a Caremark claim is possibly the most difficult theory in corporation law upon which a plaintiff might hope to win a judgment." The very high bar to plaintiff success on Caremark claims has been primarily due to the necessary element of "bad faith" by the directors (i.e., knowing and intentional violation of oversight duties) and the need to establish demand futility to bring the derivative claim. However, in the past few years, the court has let a few Caremark claims survive the pleading stage. Notably, these cases generally involved egregious facts following an extreme corporate trauma (usually involving the loss of human life and/or health). Further, in the past few years, the court has seemingly expanded the circumstances in which Caremark applies. For example, the court has: considered employment-related issues (such as sexual harassment and, more generally, employees' safety and welfare) to be "mission-critical risks" to which Caremark duties apply (McDonald's); considered cybersecurity to be a "mission-critical risk" for all online companies (Bingle/SolarWinds); stated that Caremark duties apply to "key compliance risks" even if not rising to the level of "mission-critical risks" (McDonald's); and held that Caremark oversight duties apply not only to directors but also to officers (McDonald's).

In the most recent cases, the court has emphasized the high bar to success on Caremark claims. In Caremark decisions issued in recent months-Walgreens, Skechers, ProAssurance, and Segway-the Court of Chancery has re-emphasized the high bar to success on Caremark claims. Further, noting the proliferation of Caremark cases in recent years ("once rarities,…in recent years [they have] bloomed like dandelions after a warm spring rain," Vice Chancellor Laster wrote in one decision), the court has reiterated the narrow circumstances in which Caremark would apply and has expressly discouraged the bringing of Caremark claims absent extreme circumstances.In these decisions, the court has stressed that:

  • bad faith is a necessary element of a Caremark claim under either prong of the Caremark test;
  • generally, only extreme circumstances will substantiate a claim of bad faith; and
  • Caremark liability generally applies only to legal compliance risks and not to business risks.

We note, however, at the same time, in the recent AmerisourceBergen decision (discussed below), the Delaware Supreme Court reversed the Court of Chancery's pleading-stage dismissal of Caremark claims in that case. Although the reversal was based on somewhat technical grounds, it is notable that the Supreme Court permitted Caremark claims relating to legal noncompliance to proceed notwithstanding a federal court's post-trial finding of legal compliance by the company. In our view, the decision thus confirms that, notwithstanding the other recent court opinions discussed below, the Delaware courts will still be receptive to Caremark claims in the context of egregious facts following an extreme corporate trauma.

Walgreens

In Clem v. Skinner ("Walgreens") (Feb. 19, 2024), the plaintiff-stockholders claimed that the board of Walgreens Boots Alliance, Inc. (one of the largest retail pharmacy chains in the U.S.) breached Caremarkduties by ignoring red flags of an alleged scheme relating to overfilling of, and then overbilling for, prescription insulin pens.

Facts. Walgreens allegedly had programmed its software to dispense five insulin pens (the maximum per box dispensed by the insulin manufacturer) even if fewer pens had been prescribed for the patient. The allegations first arose in 2015 in a whistleblower action in the S.D.N.Y. In October 2016, the U.S. Department of Justice opened an investigation. In January 2017, Walgreens' Audit Committee and board were informed of the problem. From April through October 2017, the Audit Committee convened six times, and at each meeting received updates from Walgreens' internal compliance, legal and audit management groups on the investigation and Walgreens' response to it. In each case, the following day, updates were provided to the full board. The whistleblower action was also discussed at several meetings between October 2017 and January 2018, which included review of a report from the chief compliance officer. In April 2018, Walgreens remedied the problem by reprogramming its system to eliminate the default setting of five pens per box. In November 2018, the DOJ moved to intervene in the whistleblower suit; and, in January 2019, the DOJ and Walgreens announced a $209.2 million settlement, which included Walgreens entering into a corporate integrity agreement with the federal government, mandating various compliance practices.

Holdings.The court dismissed the Caremark claims for failure to plead demand futility, after finding it was not substantially likely that the directors faced liability under Caremark.

Prong One. Thecourt found that the board made a good faith effort to establish an oversight system and monitor it. The plaintiffs' Complaint itself acknowledged that: the Audit Committee was tasked with overseeing the company's compliance with legal and regulatory requirements; there were regular discussions of legal and regulatory compliance risks at Audit Committee and board meetings; the Chief Compliance Officer, among others, regularly presented to the Audit Committee on compliance matters and risks; and compliance programs were implemented throughout the relevant periods. The court rejected the plaintiffs' argument that was based on the oversight systems in place allegedly being ineffective and/or inferior compared to alternative measures. The court stressed that it was in the board's discretion how to create oversight controls.

Prong Two. The court found that the plaintiffs had not sufficiently plead that the board consciously ignored red flags of company noncompliance. First, the court rejected the plaintiffs' attempt to use examples of other noncompliance at the company to establish that the board ignored red flags relating to the insulin pens issue. "Knowledge of illegality in one corner of a vast business does not mean that directors were on notice of a distinct problem in another." Second, the court rejected the plaintiffs' argument that the board's knowledge of the DOJ investigation had put it on notice of the non-compliance with respect to the insulin pens. "Whether an investigation becomes a red flag depends on the circumstances. One brought amid strong factual allegations of board knowledge of ongoing legal violations in the wake of federal government enforcement proceedings may present a red flag. The obverse is also true."

Bad faith. The court stressed that the plaintiffs had not sufficiently plead bad faith by the directors. The court noted that: Walgreens "maintain[ed] a multi-layered compliance infrastructure" (as it is in an industry subject to "a mass of laws and regulations"); the Audit Committee routinely received reports on compliance, legal and regulatory matters; and the Committee and the board were kept apprised of the developments relating to the whistle-blower action, the governmental investigation, and the company's response. Further, the corporate trauma complained of concerned "an issue well beneath the board's typical purview"-i.e., "billing practices for a single pharmaceutical product." Also, the fact that the company ultimately actually remediated the alleged noncompliance was evidence of a lack of bad faith. "The plaintiffs' grievance that the board's response came too late and did too little is incompatible with bad faith."

Key Points.

  • Bad faith is a necessary element of a Caremark claim under either of the two Caremark prongs. Bad faith-i.e., a "conscious," and "sustained or systemic failure" to exercise oversight-is required for Caremark liability, even where a board has put into place allegedly ineffective or suboptimal compliance controls and/or may have ignored red flags of noncompliance.
  • Caremark has limited applicability. The court suggested that valid Caremarkclaims are limited to circumstances where there has been a corporate "calamity" and the injury is not just "financial."
  • Most Caremark claims are invalid. The court stressed that Caremarkclaims have proliferated; and acknowledged that there have been some cases in recent years in which the court has found potential Caremarkliability at the pleading stage. These cases, however, the court noted, concerned "severe corporate trauma and rel[ied] on board records suggesting a complete failure to oversee related core risks." Most Caremarkclaims, the court stated, including in this case, have been "[f]ueled by hindsight bias," improperly seeking "to hold directors personally liable for imperfect efforts, operational struggles, business decisions, and even when the corporation is the victim of a crime." The court wrote: "In the rare event that directors cross the red line of bad faith and trauma occurs, liability can arise [under Caremark]. But more harm than good comes about if Caremarkclaims are reflexively filed whenever a government investigation is announced, a class action lawsuit succeeds, or a big-dollar settlement is reached. From a doctrinal perspective, this expansion risks weakening the core protections of the business judgment rule. From a practical standpoint, it drains resources from the very corporations that derivative plaintiffs purport to represent." The court stated that the plaintiffs, by bringing this case, had "compounded [the financial injury complained of, as the case] impose[d] years of costly litigation on Walgreens."

Skechers

In Conte v. Greenberg ("Skechers"), the plaintiff-stockholder claimed that the board of Skechers U.S.A., Inc. (a casual shoe company) breached Caremark duties by failing to impose meaningful restraints on the personal use of the company's two corporate airplanes by three company executives (including the controlling stockholders), allegedly causing harm to the corporation through excessive compensation to the executives and loss of tax benefits by the company.

Facts.The executives' employment agreements granted them "reasonable" personal use of the aircraft as a perquisite. The executives allegedly used the aircraft for personal travel at least 52 times from 2019 to 2021-with such travel, at its peak (during the pandemic), accounting for more than 50% of each airplane's use-which allegedly caused the company to lose certain favorable tax treatment and demonstrated that the second airplane was not needed. The executives paid taxes on the value of the flights they took, and, under their employment agreements, the company reimbursed them for the taxes and certain fight-related expenses, totaling $5.3 million. This airplane perquisite compensation generally represented about 0.5% to 4.9% of each executive's total compensation. (By comparison, the median value in 2015 of such perquisites to executives at S&P 500 companies allegedly was just $54,000.)

Since at least 2018, the Committee had requested information about the executives' personal use of the corporate airplanes. In March 2018, the Committee requested and received from management data and updates with respect to the executives' perquisite compensation. In April 2018, the Committee asked the CFO to provide recommendations to curtail airplane usage-but the CFO did not do so. In November 2019, the Committee asked management to draft an airplane usage policy for the Committee's review-but management did not do so. In 2021, a compensation consultant (engaged by the company for unrelated reasons) recommended that, as matter of good practice, the practice of tax gross-ups for personal use of the corporate airplanes be eliminated.

Holdings.The court dismissed the Caremark claims for failure to plead demand futility, after finding it was not substantially likely that the directors faced liability under Caremark.

Bad faith. The court held that the plaintiff had not sufficiently plead bad faith.The court rejected the plaintiff's argument that bad faith was established based on the Committee's having delegated drafting of a policy on executives' use of the corporate airplanes to management, as management was conflicted given that they relied on the three executives for their continued employment. "[D]elegating the initial drafting of the policy to potentially conflicted individuals d[id] not demonstrate bad faith because the Committee retained oversight over the process and the policy's contents." Also, the court rejected the plaintiff's argument that bad faith was established based on the Committee's ultimately not having produced a policy restricting personal use of the airplanes. The excessive personal use of the airplanes, even if in violation of the executives' employment agreements, was not "of such a scope, magnitude, or questionable legality that the only good faith response was to create a policy." The court stressed that the issue the company faced was "contained" (limited to "the use of two corporate assets by a discrete group of individuals."

Key Points.

  • How a board responds to red flags is within the board's judgment. Even where Caremarkrequires that a board respond to red flags, how it responds is within the board's business judgment. When a board has acted in response to red flags, criticism of the manner and timing of the response is insufficient to establish bad faith for Caremark purposes.
  • "Doing nothing" does not necessarily evidence bad faith. Some risks are of such a magnitude that inaction alone can support an inference of bad faith-in such cases "there is only one right answer: to take tangible action addressing that risk." But as the magnitude of the risk decreases, inaction (even if intentional) may not alone support a finding of bad faith. Here, the risk was "contained" (i.e., did not involve a "widespread operational deficiency" nor a violation of an internal policy or any regulations) and the financial amounts involved were of "a relatively minimal magnitude" in the context of the company's $3 billion in annual profits and $2.5 billion in annual operating expenses.

ProAssurance

In ProAssurance Deriv. Litig. (Oct. 2, 2023), the plaintiff-stockholder claimed that the directors of ProAssurance Corp. (a healthcare professional liability insurance provider) breached their Caremark duties by taking on increased risk without creating sufficient loss reserves.

Facts. In 2015, following industry trends, ProAssurance decided to insure a larger healthcare institution than was typical for it in the past-thus taking on greater exposure to high-severity claims. By 2018, the new insured's claims had grown more frequent. By 2020, ProAssurance announced that its loss reserves had been inadequate.

Holdings. The court dismissed the Caremark claims for failure to plead demand futility, after finding it was not substantially likely that the directors faced liability under Caremark.

The court found that the plaintiffs' allegations failed to establish that the company was engaged in illegal activity as opposed to simply having made a business judgment to take on more risk. The court wrote: "[T]he only so-called red flags were of business risks-not illegality"-therefore, "[h]ow(and whether) to respond was entirely within the directors' discretion." The court also found that, even if there had been a failure to monitor business risk, there were no allegations supporting a reasonable inference of bad faith by the directors. The court wrote: "For liability to arise, the directors' oversight failures must be so egregious that they amount to bad faith." In this case, the court noted, the board regularly received updates on the company's underwriting practices and reserves; properly delegated these tasks to management; and was guided by actuaries and auditors.

Key Points.

  • Caremark generally applies to legal compliance risks but not business risks. In a few Caremark cases (e.g., Bingle/SolarWinds), the court has suggested that, at least in extreme cases, directors may face Caremark liability not only for a failure to oversee key legal and regulatory compliance risks, but also for key business risks. In ProAssurance, however, the court emphasized that a board's business-risk decisions generally are subject to the board's business judgment and Caremark duties are not applicable. The court observed that the events in this case "quite obviously, involve[d] a commercial decision that went poorly-the stuff that business judgment is made of." The court viewed the plaintiffs' allegations as reflecting "hindsight-second-guessing of a business decision that turned out poorly," without evidence of bad faith. The court wrote: "So long as the challenged conduct is lawful, directors have broad discretion to advance the corporation's interests as they see fit"; and Caremark liability is applicable only if "the directors utterly failed to implement a reporting system or consciously disregarded a violation of positive law" (emphasis added). The court wrote: "[I]nsurance underwriting is, by its very nature, uncertain and risky,…[and] the Board was consistently-even painfully-involved in monitoring the Company's underwriting and reserves. The plaintiffs' belief that the Company's practices were not sufficiently conservative is a quibble with the Board's judgment."
  • Caremark relates to extreme events. The court stated that Caremark oversight claims "should be reserved for extreme events" (with liability arising only when the oversight failures have been so egregious that they amount to bad faith).

Segway

In Segway v. Cai (Dec. 14, 2023), Segway Inc. asserted Caremark claims against its former CEO for an alleged failure of her oversight with respect to financial accounts after discrepancies were discovered.

Facts. Segway Inc. (a personal transportation devices company) was acquired in 2015 by a company that produced similar vehicles. After the merger, Segway sold its products alongside the acquiror's, but otherwise continued to operate separately, with its own board, officers, employees, and financial and accounting systems. Cai was hired as Segway's Vice President of Finance, and soon became President. When Segway experienced a significant decline in sales, shrinking of its customer base, and rise in its accounts receivable, it responded by turning away from selling its branded products and focused instead on selling the acquiror's products, while significantly downsizing its own operations. Segway's main facility was closed and Cai's employment was terminated. It then became evident that the information Cai had been providing to the acquiror about shrinkage of customers and sales did not match the actual numbers in Segway's financial records, and that a significant portion of the accounts receivable had been improperly recorded or not booked. When the acquiror could not reconcile the discrepancies (and Cai declined the acquiror's request to help in that effort), the company commenced this action against Cai, alleging breach of her Caremark oversight duties.

Holdings. The court dismissed the Caremark claims at the pleading stage, after finding that, although Cai allegedly had "consciously disregarded" financial discrepancies in her reports to the acquiror, there were no allegations supporting a reasonable inference that she had done so in bad faith.

The court rejected Cai's contention that-as Caremark duties applicable to officers (as opposed to directors) are "context-specific" and generally limited to the scope of the officer's corporate responsibilities-bad faith is not a prerequisite for officer liability. The court, addressing officer liability under Caremark for the first time since the McDonald's decision established that officers have Caremark duties-confirmed that the same high bar to pleading a Caremark claim against a director, including the prerequisite of adequate pleading of bad faith, also applies to pleading a Caremark claim against an officer. The court found that the allegations that Cai ignored red flags with respect to problems with the company's customer base, revenues, and other financial metrics did not support an inference of bad faith for Caremark purposes. The plaintiff would have had to plead that Cai had "consciously failed to act after learning about evidence of illegality-the proverbial 'red flag'" (emphasis added).

Key Points.

  • Caremark generally applies to legal risks, not business risks. The court viewed Cai as having made "classic business decisions"-noting that the allegations were not that she had overlooked fraud, accounting improprieties or material legal violations, but rather that she had consciously ignored issues relating to customers, sales, revenues, and accounts receivable that had come to her attention, which, the court stated, were "generic financial matters [that] are far from the sort of red flags that could give rise to Caremark liability."
  • Bad faith is a predicate to Caremark liability-for directors and officers.
  • There remains a high bar to success on a Caremark claim. The court emphasized that a Caremark claim still "is possibly the most difficult theory in corporation law upon which a plaintiff might hope to win a judgment."

AmerisourceBergen

In Lebanon Cty. Empl. Rtrmt. Fd. v. Collis ("AmerisourceBergen") (Dec. 18, 2023), the Delaware Supreme Court reversed the Court of Chancery's dismissal of Caremark claims against the directors of AmerisourceBergen Corp. (one of the nation's "big three" opioid distributors).

Facts. The company had paid $6 billion to resolve claims brought by state and local governments relating to the company's role in the national opioid crisis. The plaintiffs claimed that the directors intentionally failed to cause the company to comply with regulatory requirements relating to opioid distribution. The plaintiffs alleged that the company had adopted a culture of non-compliance that prioritized profits over legal compliance and that the board had consciously and continually ignored red flags of the company's blatant noncompliance with the federal Controlled Substances Act.

Holdings.The Court of Chancery had concluded that the "avalanche of investigations without any apparent response" by the board for years, and the board's leaving in place an allegedly defective monitoring program for years, would support a red flags claim under Caremark. But the Court of Chancery dismissed the case, holding that it was "not possible" to infer that the directors and officers had knowingly ignored red flags and failed to cause the company to comply with the CSA given that, while the case was pending in the Court of Chancery, a federal court in West Virginia had issued a post-trial determination that the company had complied with the CSA. The Court of Chancery viewed that determination as "persuasive" (although "not preclusive"). The Supreme Court reversed, holding that the Court of Chancery should have evaluated the plaintiff's allegations without giving effectively decisive weight to the federal court's findings. Th Supreme Court held that, although a Delaware court can take judicial notice of questions of law from other courts, it cannot, at the pleading stage, adopt another court's factual findings through judicial notice. The Supreme Court agreed with the Court of Chancery that, without taking the federal court's findings into account, the plaintiff's allegations were sufficient to support a Caremark claim.

Key Points.

  • Delaware courts can be expected to permit Caremark claims to survive in certain circumstances. While the Supreme Court's reversal of the Court of Chancery's dismissal of Caremark claims in AmerisourceBergen was based on narrow, even technical grounds, in our view the decision supports an expectation that, notwithstanding the most recent emphasis on the high bar to success on Caremark claims, Caremark claims may well survive pleading-stage dismissal in cases involving egregious facts following an extreme corporate trauma.

Practice points arising from Caremark decisions.

  • Boards. Boards-supported by management, the audit committee, the company's outside auditors, and legal counsel-should stay focused on, and apprised of key developments with respect to, legal compliance and other risks (such as cybersecurity risks and employee-welfare risks) that are central to the business and should seek to anticipate key areas of risk that may develop in the future. Boards should seek to: identify the "mission-critical" or key risks facing the company and delegate responsibility for oversight of these risks to specific board committees; be active in establishing effective management of key risks as a corporate priority; consider setting a regular schedule for reporting from management on key risks and be proactive in seeking out additional reports when appropriate; not simply delegate to senior officers of the company the management of critical risks, but become informed about and consider how those risks are managed; not ignore (but, rather, proactively address) "red flags" (or "yellow flags") about key risks; and, importantly, create a record (such as in board minutes) of its risk monitoring and oversight efforts.
  • Management. Corporate management should seek to: establish regular processes and protocols such that the board is kept apprised of key regulatory compliance and other practices, risks, reports and responses; inform the board when it learns of "red flags" (or "yellow flags") about key risks (including, for example, complaints or reports from regulators or whistleblowers); include the board in the company's whistle-blower process; tailor risk management strategies to the company's specific circumstances and risk profile; inform the board of the practices of other companies in its industry or peer companies with respect to oversight of mission-critical risks; and integrate risk management considerations into the company's corporate strategies and decision-making generally.
  • Legal compliance. Violation of "positive law" clearly heightens the risk of Caremark liability, although there have been several cases (NiSource, LendingClub, and MoneyGram, for example) in which the court has dismissed Caremark claims at the pleading stage that were based on governmental investigations finding the company had a history of regulatory noncompliance. Successful defenses in these cases (that supported a lack of bad faith by directors) included that: the board was not aware of the regulatory noncompliance; the noncompliance was not sufficiently related to the corporate trauma that occurred; the noncompliance occurred at a different subsidiary of the company; and/or the board had taken steps to remediate the noncompliance.

Why the Court Found Larry Ellison Was Not a Controller at Oracle but Elon Musk Was a Controller at Tesla

An ongoing issue in Delaware corporate law has been how to determine who may be deemed to be a controlling stockholder. At the end of January, the Court of Chancery held that Elon Musk, who owned 22% of Tesla, was a controller with respect to a self-interested transaction (i.e., a 10-year $58 billion equity-based compensation package for Musk as CEO)-while last year the Court of Chancery held that Larry Ellison, who owned 28% of Oracle, was not a controller with respect to his self-interested transaction with Oracle (i.e., the company's acquisition of NetSuite, in which Ellison held a 40% equity stake).As a result of these decisions with respect to control, the Oracle transaction was subjected to deferential business judgment review and the case was dismissed; while the Tesla transaction was subjected to entire fairness review (Delaware's most exacting standard), the court held that the transaction was not fair as to price or process, and the transaction was declared invalid.

Why was Ellison not, but Musk was, a controller-when both were "superstar CEOs" upon whom their companies concededly depended for vision and leadership; both clearly had tremendous influence at their companies; and Musk owned a smaller minority equity stake in Tesla than Ellison owned in Oracle?

The critical factors in each case appear to have been:

  • the composition of the board (with the Oracle board including directors the court viewed as independent of Ellison, and the Tesla board including no directors the court viewed as independent of Musk);
  • the transaction process (with, first, the Oracle special committee having negotiated hard for the company and its stockholders, and the Tesla committee not having negotiated "at all" in the court's view; and, second, the Ellison having been effectively isolated from the process and, in the court's view, not having tried to control the transaction, and Musk having been closely involved in the process and, in the court's view, having controlled it); and
  • the context of the transaction (with the Oracle situation involving a acquisition that the board had long considered to be attractive for the company, and the Musk situation being the setting of Musk's compensation).

In other words, these were not cases where the court inferred control based on the stockholder's overall influence over the company, making it hard to reconcile why one superstar CEO was a controller but the other (with more shares) was not. Rather, these cases were decided based on the court's highly facts-specific inquiry into the transaction process and the control actually exerted (or not) by the putative controllers.

Oracle

In Oracle, the court found that, although Ellison had the potential to control, he did not actually exert control over the challenged transaction. The Oracle special committee and board that approved Ellison's self-interested transaction (i.e., the company's acquisition of NetSuite, in which Ellison also had a significant equity stake) included directors that the court determined to be independent. The court found that, with respect to the transaction at issue, the directors were "unmolested by [Ellison's] influence"-as Ellison had "scrupulously avoided" discussing the transaction with the committee and had recused himself from its discussions of the transaction throughout the process. Further, there had been previous instances indicating that the board was "not afraid to stand opposed to Ellison."

Notably, in Oracle, the court had decided at the pleading stage of litigation that is was reasonably conceivable that Ellison was a controller and therefore that entire fairness review likely would apply. After trial, however, the court determined that Ellison was not a controller and therefore business judgement review applied-underscoring the highly facts-intensive nature of the judicial inquiry as to controller status. The court found that Ellison did not generally exercise control over Oracle's operations and that, although he could have exercised control over the transaction at issue if he had desired to do so, in fact he did not attempt to exert control over the transaction.

The court stressed that, while Ellison had proposed the transaction, Oracle had long viewed NetSuite as a potential target to be acquired; Ellison had expressed views against an acquisition of NetSuite a few years earlier; the special committee formation process did not involve Ellison; the committee was aided by experienced and independent advisors; the committee established "rules of recusal" to isolate Ellison from the process (which included prohibiting Ellison from discussing the transaction with anyone but the committee; requiring Oracle employees involved in the process to be informed of Ellison's recusal; and forbidding Oracle officers and other employees from being involved in the process other than at the direction of the committee); the committee ran the negotiation process (and the CEO-allegedly, Ellison's surrogate on the committee-did not act to advance Ellison's interests); the committee met fifteen times over seven months; and, critically, the committee engaged in "vigorous," "hard-nosed" negotiating, investigated alternatives, thoroughly considered the transaction, and was prepared to let the transaction die when NetSuite countered at a price the committee deemed unacceptable (all of which indicated that Ellison did not improperly influence the process).

The court wrote in Oracle: "The concept that an individual-without voting control of an entity, who does not generally control the entity, and who absents himself from a conflicted transaction-is subject to entire fairness review as a fiduciary solely because he is a respected figure with a potential to assert influence over the directors, is not Delaware law."

Tesla

By contrast, in Tornetta v. Musk ("Tesla"), the Tesla compensation committee and board that approved Musk's self-interested transaction was comprised entirely of directors who, in the court's view, had longstanding business or personal ties to Musk, or owed their wealth to him. Further, the court viewed the Tesla committee as not having negotiated the compensation plan, but as having focused on providing Musk with what he wanted, without even determining whether the extraordinary amount of compensation was necessary to retain and incentivize Musk. Further, Musk not only apparently proposed the compensation amount, but controlled the timing of the approval process.

The court stressed the "unfathomable" amount of the compensation that was granted; there was no clearly independent director on the compensation committee or the board; there was barely any evidence of negotiations at all (with directors testifying that they viewed the process as non-adversarial, and a collaboration with Musk to set compensation that was "fair" to him and would "please" him (so that he would be incentivized to focus on Tesla rather than spending his time on his many other companies and projects); the committee working alongside Musk, almost as an "advisory body" to him; it appeared unlikely that the plan was necessary to retain and incentivize Musk-as Musk's 22% equity interest in the company would have given him incentive to achieve Tesla's market capitalization growth objectives, and as there were no requirements that Musk would have to devote any specified amount of time on Tesla as opposed to his other interests; and the committee's process was rushed (except when Musk decided to slow it down) and casual (without formal presentations or a traditional benchmarking analysis, and with directors testifying that they could not remember meetings at which important elements of the grant were discussed).

The court wrote in Tesla: "In the final analysis, Musk launched a self-driving process, recalibrating the speed and direction along the way as he saw fit. The [unfair] process arrived at an unfair price."

Of note, in Tesla, the court took an arguably more expansive approach than usual in evaluating director independence. In particular, the court viewed directors' longstanding service on the same boards as indicating a business relationship sufficient to call into question their independence from each other. In this case, the court viewed three of the eight directors as having extensive business and/or personal relationships with Musk-meaning that they and Musk, constituting half of the board, were not independent. The court also noted that the working group with responsibility for the compensation plan included management members who were "beholden" to Musk-for example, the General Counsel, who acted as the primary go-between between Musk and the committee, was Musk's former divorce attorney (whose admiration for Musk had "moved him to tears during his deposition"). Perhaps most unusually, in evaluating directors' business interests, the court took into consideration factors such as the directors' total derived compensation as compared to the director's total net worth; a director's large personal investments in Musk-controlled entities (including his family's charities); and how the substantial director compensation that was received impacted the director (such as by being "life-changing" or creating "dynastic or generational wealth"). In addition, the court factored in any such interest of a director related to Musk's brother (who was a Tesla director but had no other role at the company). Further, the court viewed a director's going on a Musk family vacation, attending Musk's children's birthday parties, or attending Musk's second wedding, as establishing a personal relationship that compromised independence.

In conclusion, these two cases reflect the highly facts-intensive nature of judicial inquiries into controller status (and, relatedly, director independence)-and, thus, the uncertainty of result, absent clear removal of the purported controller from the process, clear independence of the directors, and/or clear effectiveness of the special committee on behalf of the corporation and its stockholders.

Most recent developments-Oracle:In February 2024, the court rejected the plaintiffs' request for a mootness fee (of $5 million), despite their trial loss. The plaintiffs argued that during the pendency of the litigation and following the court's denial of the pleading-stage motion to dismiss, Oracle appointed two new independent directors. The court found that the appointment of the new directors was too disconnected from the purpose of the litigation to warrant a mootness fee-noting that the existing directors had not breached their fiduciary duties, thus the new directors did not supplement the already loyal board in a way that provided a corporate benefit with respect to the transaction at issue in the litigation. Moreover, the court noted, athe litigation had not focused on director independence and the plaintiffs had never sought appointment of new independent directors. The court wrote: "[N]ot even great counsel can wring significant stockholder value from litigation over an essentially loyal and careful sales process."

Most recent developments-Tesla:In April 2024, Tesla announced that it has engaged a proxy solicitation firm to seek proxies from stockholders (not affiliated with Musk) to ratify Musk's compensation plan that the court rescinded, and also to approve a reincorporation of the company from Delaware to Texas. Of note, since the court's January decision rescinding the compensation plan, Tesla's results and stock price have declined-with the company reporting a decline in deliveries for the first time in four years, results failing to meet market expectations, and the company announcing layoffs of about 10% of its workforce.

Director Elected in Activist Campaign Was Not Entitled to Share Confidential Company Information with the Activist-Icahn v. deSouza

In connection with a stockholder activist campaign by certain Icahn-affiliated funds (the "Icahn Funds") against Illumina, Inc., the Icahn Funds (which collectively owned less than 2% of Illumina's stock) launched a proxy contest for three seats on Illumina's board. One of the Icahn Funds' nominees, who was also an employee of a different Icahn-affiliated entity, was elected to the board (the "Icahn-Affiliated Director"). The Icahn-Affiliated Director then obtained and shared confidential and privileged company information with the Icahn Funds, which the Icahn Funds used in crafting a derivative complaint against certain current and former Illumina directors.

In Icahn Partners v. deSouza, the Court of Chancery, in a letter opinion (Jan. 16, 2024), ruled that the Icahn-Affiliated Director was not entitled to share the information with the Icahn Funds. The Delaware Supreme Court, in a letter ruling (Apr. 11, 2024), rejected interlocutory appeal of the issue.

In deSouza, the Court of Chancery acknowledged that directors generally are entitled to broad access to company information. Further, the court acknowledged that it has not drawn bright-line rules relating to directors' sharing of confidential or privileged company information. Generally, the Delaware courts have reasoned that, when a stockholder designates a director, that director acts as the stockholder's representative to the board and the director can share the information he or she has about the company with the designating stockholder; and that, when a director is a controller or fiduciary of the stockholder, it is unrealistic that information the director has (in his or her "one brain") could be segregated from the director's thought process when fulfilling his or her fiduciary duties to both the company and the designating stockholder. Accordingly, a long line of cases has established that a director can share confidential or privileged company information with the stockholder(s) that designated the director to the board if: (i) the stockholder, either through its voting power or contractually, has the right to designate a director; or (ii) the director is a controller or fiduciary of the stockholder.

The Court of Chancery had reasoned that the Icahn-Affiliated Director's "lack of a fiduciary role with the Icahn Parties and the Icahn Parties' lack of contractual rights to designate directors to the Illumina board and limited voting power made the case distinguishable from cases holding a director may share confidential or privileged information with a stockholder." In other words, the Court of Chancery found that the combination of the director's nomination by the Icahn Funds and his employment by another Icahn-affiliated entity did not satisfy the requirements noted under (i) and (ii) above. With respect to (i), nomination and ultimate election of the director was not the equivalent of holding a contractual right to designate, or having the ability to exercise voting power to elect, a director. With respect to (ii), the Icahn-affiliated entity's employment did not create a dual-fiduciary-with-just-"one-brain" situation that would have made it unreasonable to expect that information would not be shared-because the employment did not create a fiduciary relationship with or influence over the Icahn Funds and, even if it had, an employment-based fiduciary relationship would not take precedence over the fiduciary duties owed to the company by a director.

The Court of Chancery expressly rejected the Icahn Funds' contention that recent Delaware precedents support that a company has no reasonable expectation of confidentiality with respect to the sharing of company information by a director with a stockholder that nominated the director. Also of note, the Court of Chancery found that it was not unreasonable for Illumina to expect that the Icahn-Affiliated Director would not share with the Icahn Funds the company information provided to him, given that the director had expressly agreed to abide by Illumina's code of conduct, which prohibited the sharing of confidential information with others.

We note some complexity inherent in the court's distinction between nominating and designating a director. In many agreements containing governance rights (including for example, activist settlement agreements), a stockholder is granted the right to designate nominees to the board, with the company bound to recommend such nominees for election. Moreover, in the recent Moelis decision, the Court of Chancery held that a right to designate nominees, when provided in stockholders agreement with the company, is facially valid, while a restriction of the company requiring it to recommend such nomination, is facially invalid (under DGCL Section 141(a)). When rights relating to directorships are granted, whether in activist settlement agreements or otherwise, the parties should keep in mind the complexities suggested by Moelis and deSouza with respect to these distinctions.

Other Developments of Note

Understanding the Proposed DGCL Amendments Being Considered Regarding Governance Rights in Stockholder Agreements

The Moelis decision (Feb. 24, 2024) called into question the facial validity of the common, long-standing corporate practice of granting governance rights to key stockholders in a stockholders agreement, in light of DGCL Section 141(a)'s mandate that the affairs of a corporation be managed by its board of directors except to the extent provided otherwise in the corporation's charter. (See our Del. Dispatch column: "How Moelis Upends Stockholders Agreements.") In response to the decision, the Council of the Corportion Law Section of the Delwaare State Bar Association has proposed certain amendments to the DGCL (the "Proposed Amendments"), to bring the statute in line with corporate practice relating to granting governance rights in stockholders agreements. (See our Briefing, "Proposed Amendments Would Clarify Delaware Statutory Requirements, to Align with M&A Market Practice, Following the Moelis, Activision and Crispo Decisions.")

We note, first, that, although the Council's recommendations usually are adopted by the Delaware legislature, it is unclear whether that will be the case here. We note also that there has been some confusion over what the Proposed Amendments actually provide and would permit.

Moelis held that governance rights that intrude on areas generally within the board's jurisdiction are facially invalid. The Proposed Amendments, if adopted, would provide that, in an agreement with current or prospective stockholders, a corporation can agree, with respect to actions specified in the agreement, (a) to restrict or prohibit the corporation from taking such actions; (b) to require the approval of one or more persons or bodies before the corporation can take such actions; and (c) to covenant that the corporation or one or more bodies will take, or refrain from taking, such actions. Thus, it appears, the Proposed Amendments would empower a corporation to agree to (a) not take specified actions; (b) take specified actions only if approved by specified persons (say, a specified stockholder; or certain directors on the corporation's board, such as those designated by the stockholder); and (c) take, or not take, specified actions.

Importantly-and overlooked in much of the commentary on the proposed amendments-the Synopsis released with the proposed amendments confirms that the amendments would not alter a board's fiduciary duties in connection with entering into or acting under any such agreement. Accordingly, while the amendments are drafted with broad language, the intention appears simply to prevent control or governance rights in stockholders agreements from being invalid on their face. Rather, the inquiry would be whether the board acted within its fiduciary duties in granting or enforcing the rights. For example, under the Proposed Amendments, granting a stockholder the right to designate directors and require that the board recommend those designees would not be facially invalid under the DGCL-a board could enter into such a contract. However, the issue would remain whether the board had sufficient justification for entering into the agreement, and for acting in compliance with (rather than breaching) the agreement, at the time the board recommends the stockholder's designees.

We note that the proposed amendments do not resolve certain issues left unresolved in Moelis. For example, there is an issue as to which agreements are subject to the mandate of DGCL Section 141(a) applies. The court stated in Moelis that Section 141(a) applies to internal governance agreements (such as stockholders agreements) but not to external commercial agreements (such as credit agreements). The court acknowledged a "line-drawing issue" with respect to hybrid agreements that include both governance and commercial terms-and suggested that the inquiry as the applicability of Section 141(a) would be whether governance was "the point" or the point of the governance provisions was simply to protect the commercial arrangement. The Moelis decision expressly left open, and the amendments do not address, whether, for example, an activist settlement agreement would, or would not, be subject to Section 141(a).

Focus on Overlapping Directors Appointed by PE Firms

The director of the FTC's Competition Bureau, Henry Liu, was reported as having described overlapping directorates as a high priority for the Bureau. (The Bureau analyzes mergers and recommends to FTC commissioners whether transactions should be cleared or blocked.) In evaluating mergers, the FTC has been focusing in recent years on whether private equity firm holding companies, via a merger, would place onto the target company's board directors who also serve on the board of any company with which the target competes. Notably, last year, the FTC conditioned the merger pursuant to which EQT acquired two companies owned by PE firm Quantum Energy on limitations with respect to director overlaps on the companies' respective boards. This year, the DOJ and FTC have announced several resolutions requiring the unwinding of such board overlapping arrangements. Accordingly, although many overlapping directorates provide meaningful and valid business advantages, the potential antitrust risk must be considered carefully.

Court of Chancery Amplifies When Compounded Interest Will be Awarded on Judgments-Brown v. Court Square

In Delaware, prejudgment interest on an award by the court is provided to a plaintiff as a matter of right, and it accrues from the date payment was due to the plaintiff. As part of its discretion to fashion an appropriate remedy, the Court of Chancery has broad discretion in setting the rate of interest and awarding either simple or compounded interest. Given the market reality that even the most unsophisticated of litigants can obtain compounded interest on their money from banks, the Court of Chancery generally has viewed compounded interest as necessary for a plaintiff to be fully compensated and a defendant to fully disgorge its undue profits. At the same time, under existing law, the Delaware Superior Court (as it is not a court of equity) must award interest pursuant to the Delaware statute, which provides a statutory rate and has been interpreted as requiring simple interest only. Accordingly, while the Court of Chancery can award compounded interest (and generally has done so), the Superior Court cannot.

Last year, the Court of Chancery, in Cantor Fitzgerald v. Ainslie (Apr. 2023), noted that the "split" between the Court of Chancery and the Superior Court with respect to awarding interest provides an incentive for plaintiffs to try to plead a basis for filing their otherwise legal claims in the Court of Chancery. In Ainslie, to neutralize that incentive, the Court of Chancery denied compounded interest, reasoning that, where the damage case before it is identical to a claim that could have been brought in Superior Court were there no need for the Court of Chancery to decide other equitable issues, the Court of Chancery should follow the "norm" of the Superior Court, which is simple interest.

In a recent ruling in Brown v. Court Square (Apr. 17, 2024), the Court of Chancery acknowledged that "policy considerations concerning forum shopping might warrant" awarding simple interest to the plaintiff (as the court did in Ainslie), but Chancellor Kathleen St. J. McCormack held that such award should not be made as it would be "manifestly unfair" to the plaintiff. (In a footnote, the Chancellor suggested that "[c]larity from the Delaware Supreme Court concerning whether the Superior Court has the discretion to award compound interest would also address forum shopping concerns.") The Chancellor stressed that the parties in Brown (an investment firm and its former partner) were both sophisticated. As such, the Chancellor wrote: "[There was] no doubt that [the defendant] has earned the equivalent of compound interest on the sum it owe[d] to [the plaintiff], which [the plaintiff]…could have earned if [the amount owed to him by the plaintiff] had not been wrongfully withheld. Simple interest would, therefore, unjustly deprive [the plaintiff] and reward [the defendant]. Compensatory and restitutionary concerns thus call for compound interest." Further, the Chancellor reasoned that the parties, by having consented to jurisdiction of the Court of Chancery in their agreement that was at issue, "intended that the norms of this court would govern their dispute."

We would emphasize that the court based its decision in Brown on the general principle that simple interest would be unfair given the easy availability to all litigants of compounded interest on their money. But the court did not simply hold that the Court of Chancery, as a general matter, should always award compounded interest rather than simple interest. Nonetheless, the decision seemingly would support such a view absent distinguishing factors-which might be, for example, that there is some clear indication in a case that the plaintiffs were forum-shopping, or that the litigants were unusually un-sophisticated or for some other reason not likely to have been able to obtain, or to have obtained, compounded interest.

Fried Frank M&A/PE Briefings Issued this Quarter:

This communication is for general information only. It is not intended, nor should it be relied upon, as legal advice. In some jurisdictions, this may be considered attorney advertising. Please refer to the firm's data policy page for further information.