Notable Delaware Corporate Decisions 2005: Delaware-Centric Musings on Disney, TOYS "R" US, TCI, Unisuper, and Examen

    While the issuance of the much anticipated Court of Chancery decision involving hiring and firing of Michael Ovitz by The Walt Disney Company, stole much of the national limelight in 2005, the Delaware courts rendered several other notable decisions over the course of the past year on topics of interest to corporate practitioners.

    In the area of deal protections, the Court of Chancery issued the Toys “R” Us decision, an analytical roadmap for judicial examination of the reasonableness of board decisions in the Revlon context.  In the TCI decision, the Court of Chancery highlighted the importance of a properly structured and independent special committee process in the context of a transaction that contemplates a premium to high-vote stock over low-vote stock, highlighting the need in such a context for targeted financial advice and an appropriate fairness opinion.  The Court of Chancery in its Unisuper decision raised interesting questions relating to the ability of a board of directors to bind itself contractually to its stockholders to submit the continuation of a stockholder rights plan to a stockholder vote.  Finally, in Examen, the Court of Chancery addressed the applicability of the California Corporations Code to a Delaware corporation and found that Delaware law governed the question whether a class vote of preferred stock was necessary to approve a merger of a quasi-California corporation. Each of those decisions is described in more detail below.

I. The Duty of Good Faith: Disney

    Front and center on the national legal stage this year was the Disney trial, which consumed thirty-seven trial days in the Court of Chancery.  The post-trial decision promised corporate practitioners a long anticipated explication of the parameters of the business judgment rule in the post-Enron era, and in light of the newly fashionable fiduciary duty of good faith.

    To understand fully the saga that is the Disney litigation, it is instructive to begin with the 2003 decision of the Court of Chancery denying defendants’ motion to dismiss.[2]  At issue in that decision was the legal sufficiency of a shareholder complaint seeking to impose on the directors of Disney personal liability for damages to the company allegedly attributable to the board’s decision to hire and promptly terminate Michael Ovitz as Disney’s President, decisions which triggered substantial severance payments to Ovitz under employment contract on which the ink was barely dry.  In its 2003 decision, the Court of Chancery refused to dismiss the complaint, finding that the plaintiffs had adequately alleged facts overcoming the business judgment presumptions typically deemed applicable to the decisions of a fully-informed and disinterested board of directors by virtue of allegations calling into question the good faith of the directors in making the challenged decisions.[3] 

    Indeed, the amended complaint in the Disney I case alleged complete director abdication of authority with respect the hiring and firing of the company’s President, a decision of sufficient significance to the company to have warranted the board’s attention.  The complaint alleged that, when Mr. Ovitz was hired, the board’s compensation committee and the board itself paid scant attention to the terms of employment terms, leaving the details instead to be negotiated by Mr. Ovitz and his “close friend,” Michael Eisner, Disney’s Chief Executive Officer.  The complaint further asserted that neither the compensation committee nor the full board reviewed any drafts of the employment agreement, spent any significant time on the issue at their respective meetings, or obtained expert advice concerning the reasonableness of the generous terms granted to Mr. Ovitz.[4]  Moreover, while the final agreement differed materially from the terms summarized for the compensation committee, in particular regarding termination, no further board or committee discussion occurred.[5]

    With respect to Mr. Ovitz’s quickly ensuing termination, the complaint averred that the board took a similar “ostrich-like approach.”[6]  Indeed, the shareholders charged, there was no input from or review by either the Compensation Committee or the full board with respect to the terms of his departure, even after the termination arrangement was publicly disclosed and after the resulting and rather considerable payout was accelerated by one month, and even though board approval was allegedly required for these actions. Instead, the board “chose to remain invisible in the process.”[7]

    In rejecting the defendants’ arguments that these charges were insufficient as a matter of law, the Chancellor focused on the plaintiffs’ claims of willful neglect on the part of the board.  The Court conceded that the threshold business judgment presumptions might well have sufficed to defeat the complaint had the allegations permitted the court to presume that “the board had taken the time or effort to review [its] options, perhaps with the assistance of expert legal advisors.”  If true, however, the allegations, “imply that the defendant directors knew that they were making material decisions without adequate information and without adequate deliberation, and that they simply did not care if the decisions caused the corporation and its stockholders to suffer injury or loss.”[8]  Accordingly, those claims were held sufficient to rebut the presumption of good faith on the part of the board and thus to survive a motion to dismiss:

Specifically, plaintiff’s claims are based on an alleged knowing and deliberate indifference to a potential risk of harm to the corporation.  Where a director consciously ignores his or her duties to the corporation, thereby causing economic injury to its stockholders, the director’s actions are either “not in good faith” or “involve intentional misconduct.”[9]

    The matter thus proceeded to trial, following which the Delaware Court of Chancery rendered its opinion on August 9, 2005.[10]  The Court of Chancery analyzed in detail all the evidence and arguments and concluded that the defendant directors had not breached their fiduciary duties nor committed waste in connection with the hiring or termination of Michael Ovitz and entered judgment in favor of defendants on all counts.

    In its opinion, the Court observed that the existing precedent did not clearly declare whether Delaware law recognized a free-standing fiduciary duty of good faith.  The Chancellor suggested that the concept of good faith is not an independent duty, comprising autonomous standards of conduct, but rather an overarching concept inherent in a fiduciary’s duties of due care and loyalty:

Fundamentally, the duties traditionally analyzed as belonging to corporate fiduciaries, loyalty and care, are but constituent elements of the overarching concepts of allegiance, devotion and faithfulness that must guide the conduct of every fiduciary.  The good faith required of a corporate fiduciary includes not simply the duties of care and loyalty, in the narrow sense that I have discussed them above, but all actions required by a true faithfulness and devotion to the interests of the corporation and its shareholders.[11]

    The Court noted that the presumptions of the business judgment rule could be rebutted if a plaintiff were to prove by a preponderance of the evidence an act of bad faith on the part of fiduciaries.  While the Court explicitly refused to “create a definitive and categorical definition of the universe of acts that would constitute bad faith,” stating that to do so, would “misconceive how…the concept of good faith operates in our common law of corporations,”[12] the Court nonetheless provided a non-exclusive list of examples of acts of bad faith, each such example positing an element of intent.  In particular, the Chancellor noted that a failure to act in good faith may be shown where a fiduciary:

• “intentionally acts with a purpose other than that of advancing the best interests of the corporation;”

• “acts with the intent to violate applicable positive law;” or

• “intentionally fails to act in the face of a known duty to act, demonstrating a conscious disregard for his duties.”[13]

    In applying the facts of the case, the Court concluded that the Disney board had not acted in bad faith in connection with the hiring of Ovitz and the approval of his compensation arrangement.  Although repeatedly chastising the board members for not acting in accordance with best practices, most particularly the failure of the CEO to keep the board informed in stretched the bounds of his authority to act without specific board direction, the Court refused to find that a breach of duty.  The Chancellor found that the CEO nevertheless had acted in good faith and in the best interests of the Company, and that the remaining board members who ultimately approved Ovitz’s hiring did not support a finding that they intentionally shirked or ignored their duties.  The Court also concluded that Eisner did not act in bad faith when he decided to terminate Ovitz.  In particular, the Court found that Eisner, as the Chief Executive Officer, had the authority to terminate Ovitz and that the board was not required to act in connection with that termination.

    In reaching those conclusions, the Chancellor leaned heavily and, to many, reassuringly, on the business judgment rule, as it has been understood traditionally.  The Chancellor noted that “the greatest strength of Delaware’s corporation law” – and the business judgment rule in particular – is the fact that corporate fiduciaries, although held to “a high standard in fulfilling their stewardship over the assets of others,” are granted “wide latitude in their efforts to maximize shareholders’ investments” when they act “faithfully and honestly on behalf of those whose interests they represent.”[14]

    Differentiating between the role of the Court to provide a remedy for breaches of fiduciary duty and the role of the market to provide a remedy for bad business decisions, the Court reasoned as follows:

Even where decision-makers act as faithful servants, however, their ability and the wisdom of their judgments will vary.  The redress for failures that arise from faithful management must come from the markets, through the action of shareholders and the free flow of capital, and not from this Court.  Should the Court apportion liability based on the ultimate outcome of decisions taken in good faith by faithful directors or officers, those decision-makers would necessarily take decisions that minimize risk, not maximize value.  The entire advantage of the risk-taking, innovative, wealth-creating engine that is the Delaware corporation would cease to exist, with disastrous results for shareholders and society alike.  That is why, under our corporate law, corporate decision-makers are held strictly to their fiduciary duties, but within the boundaries of those duties are free to act as their judgment and duties dictate, free of post hoc penalties from a reviewing court using perfect hindsight.  Corporate decisions are made, risks are taken, the results become apparent, capital flows accordingly, and shareholder value is increased.[15]

    The Court’s decision in Disney II thus resoundingly reaffirms the importance of the business judgment rule and offers much needed guidance to directors and officers with respect to the still-elusive concept of good faith as an element of fiduciary responsibility.

    In addition, while the Court made clear that Delaware law does not hold fiduciaries liable for a failure to comply with corporate governance “best practices” prevailing at the time a corporate decision is taken,[16] it also indicated instances in which, in its view, the Disney board failed to comply with the best practices of ideal corporate governance, in furtherance of its expression of hope that the opinion “may serve as guidance for future officers and directors — not only of The Walt Disney Company, but of other Delaware corporations.”[17]

    Practical lessons from Disney II for fiduciaries to consider in assessing their continuing compliance with the duty of care and, to the extent implicated by an intentional or conscious failure to satisfy the duty of care, good faith, include the following:

• The need for consultation between an executive and board members, or among board members, that occurs on an individual basis and outside of a formal board or committee meeting is less helpful than consultation in the context of a formal meeting. Informal consultation on an individual basis results in members of the board or committee being unevenly informed.[18]  Also, informal consultation outside of a formal meeting is largely undocumented, leaving the board with an insufficient record to establish that proper deliberation and care with respect to a matter occurred.  Analogously (though not a consideration in Disney), where action is taken by a board pursuant to unanimous written consent in lieu of a meeting, care should be taken to properly document that the directors acted in an informed manner.

• A board should continually assess potential conflicts of interest in the performance by officers and other board members of their respective duties.  While the Court expressly found that Mr. Eisner’s twenty-five year friendship with Mr. Ovitz did not prevent him from being disinterested in his negotiation of the transactions between Mr. Ovitz and The Walt Disney Company, a failure of other board members to consider and evaluate whether it was appropriate for Mr. Eisner to act as one of the company’s lead negotiators in the matter could be relevant in determining whether the other board members were exercising adequate oversight of the process.

• Adequate time should be allotted at scheduled board meetings for consideration of material matters.  In this case, the Disney compensation committee met for only one hour to consider the Ovitz employment agreement along with four other matters.  Also, board meeting minutes should be detailed enough that it is later possible for the board to establish, or a neutral fact finder to determine, the approximate length of time spent considering a matter of importance.

• Every board member needs to be able to establish his or her own fulfillment of fiduciary duties.  Delaware courts will evaluate compliance, and liability, on an individual by individual basis.[19]  While it is neither realistic nor desirable that an entire board or committee conduct negotiations on behalf of a corporation, directors taking the early lead in negotiations need to keep other members of the board informed of the substance of such negotiations, and communicate all material information to them for their consideration before action is taken.

• The taking of action by an executive with respect to a matter prior to formal board action gives rise to an inference that the board’s later approval is a mere “rubber stamp” of the executive’s action.  While execution of an employment letter agreement by Mr. Ovitz and Mr. Eisner on behalf of the company prior to board approval was not legally binding upon the company, this action, coupled with the public announcement of Mr. Ovitz’ hiring, placed inappropriate pressure on the board to approve this action.[20]

• All board or committee members should have the opportunity to review written materials regarding an important action prior to their decision.  Where the action involves execution of an agreement on behalf of the corporation, although not strictly required, the directors should ideally review the agreement itself.  At a minimum, they should review a written summary of the agreement’s material terms.[21]

• Where further negotiation of an agreement results in a material change in the terms most recently reviewed by the board, these changes should be clearly communicated to the board prior to taking of action on behalf of the corporation.

• Reliance on the advice of experts or outside counsel, including care in the selection of experts, should be properly documented.  The expert’s advice should ideally be memorialized in writing.  In the Opinion, the Court was critical of board members’ failure to document in writing legal advice they received concluding that Mr. Ovitz could not be terminated for “cause” as defined in his employment agreement, which would have allowed the company to avoid the large severance obligations that, in part, gave rise to the lawsuit.[22]  It is helpful to the record to have an expert relied upon present at the board of committee meeting at which the action is considered, though not strictly required.[23]

    An appeal of the Court of Chancery’s Disney II decision is currently pending before the Delaware Supreme Court.  Briefing and oral argument on that appeal have been completed and the litigants currently are awaiting a decision.  One may reasonably expect that the Delaware Supreme Court will offer in its ruling a further explication of the duty of good faith and its place among the elements of fiduciary responsibility under Delaware law.

II. Revlon Duties and Deal Protections: Toys “R” Us.

    The nature and scope of deal protection provisions often are at the center of merger negotiations.  Acquirors have an interest in obtaining the strongest deal protections permissible under the law, while target boards often have an interest in limiting deal protections to preserve their options and, most particularly, to provide increased flexibility in the event of a later arriving topping bid.  The recent Toys “R” Us decision confirms that, except in the most egregious situations,[24] Delaware law typically disdains the application bright-line rules to determine whether challenged deal protections are legally permissible.[25]  The Toys “R” Us decision indicates that Delaware courts more often will engage in a context specific analysis of deal protections in an effort to determine, under the particular facts presented, whether the target board acted reasonably in accepting the deal protections at issue.

    At issue in Toys “R” Us was a merger involving Toys “R” Us, Inc. (“Toys “R” Us”) and an acquisition vehicle formed by a group led by Kohlberg Kravis Roberts & Co. (the “KKR Group”).  The merger was the result of a search by Toys “R” Us for strategic alternatives following a dismal holiday season in December 2004.  On January 8, 2005, the Chief Executive Officer confirmed in a call to analysts that the company likely would consider strategic options.  Thereafter, the board of directors, consisting of nine independent directors and the Chief Executive Officer, met to consider embarking on a process to search for strategic alternatives and hired financial and legal advisors to assist them in that process.

    Because of the public announcement that the company was interested in exploring strategic options, several informal inquiries were made, including inquiries by financial buyers regarding the possibility of purchasing some or all of the company, and inquiries by other retailers with respect to purchasing only the company’s real estate holdings.  The board of directors decided to refrain from engaging in a discussion about a sale of some or all of the company until a strategic process was chosen.  The board of directors met several times during June and July 2004 and discussed the various options with their advisors.  At those meetings, the board considered alternatives primarily with respect to its two largest divisions -- Global Toys, which operated the company’s toy stores, and Babies “R” Us, which operated specialty stores selling products for babies and expectant mothers.

    In late July, the board received a formal indication of interest to purchase Global Toys from Cerberus Management, L.P. and GS Capital Partners (the “Cerberus Group”).  The financial advisor found the offer to be favorable and a board meeting was convened on July 27, 2004 to discuss the offer.  The financial advisor also received an indication of interest from Apollo Advisors for the purchase of Global Toys.  The board instructed its financial advisor to inform the Cerberus Group and Apollo Advisors that the Company was unable to engage in discussions about the offers until after a board meeting scheduled for August 10, 2005.  The board then directed its financial advisor to put due diligence materials together so that they could canvas the market.  The board met on August 10, 2005 and, after a lengthy meeting, eventually approved a strategy to separate Global Toys from its second largest division, Babies “R” Us, whether by a sale of Global Toys or a spin-off of Babies “R” Us.  The company announced that strategy in a press release and the financial advisor began to market Global Toys.

    The board’s financial advisor engaged in a market canvass, contacting 29 potential financial buyers.  The financial advisor did not contact any strategic buyers after concluding that no strategic buyers had any interest in Global Toys other than in the real estate assets of the company.  After a lengthy due diligence period and bidding process, the bidders were whittled down to a group of four, who submitted a series of final bids in February and March 2005.  During that final bidding process, the Cerberus Group, which had since grown in size, asked permission to make a bid for the entire company.  The board let it be known to the Cerberus Group through their financial advisor that a bid for the entire company was welcome.

    Meanwhile, the process continued with a series of final bids, but with no invitation by Toys “R” Us to the other bidders (or a public announcement) that a bid for the entire company would be considered.  Rather, the financial advisor was instructed to focus on a sale of Global Toys.  It soon became apparent to the board, based on the value of the bids, that a sale of the entire company might be in the best interests of the stockholders.  When the Cerberus Group increased its bid for the entire company, the board decided for the first time to request bids for the entire company from the remaining bidders only.  In reaching that decision, the board considered the risks of requesting a change in the bidding process at such a late stage, as well as the possibility of opening up the bidding process to all potential bidders and another canvas of the market.  The board agreed that it was too risky to seek new bidders, and that only bids from the final bidders for the entire company would be sought.  Ultimately, the board accepted a bid from the KKR Group.  The resulting merger agreement contained two important deal protection provisions: (i) a termination fee provision, and (ii) a “relatively non-restrictive no-shop clause” that contained a matching right.

    The termination fee provision required the company to pay a fee of $247.5 million, equal to 3.75% of the equity value or 3.25% of the enterprise value of the transaction, if one of the following event occurred:

Toys “R” Us terminated the merger agreement to accept a higher bid;

The KKR Group terminated the merger agreement because the Toys “R” Us board changed its recommendation;

The Toys “R” Us stockholders did not approve the merger agreement at a time when another offer to acquire the company existed and the company consummated an alternative transaction within one year;

The merger agreement terminated by passage of the drop dead date at a time when another offer to acquire the company exists and the company consummated an alternative transaction within one year.

The merger agreement also provided for the reimbursement of up to $30 million of expenses if the merger agreement was terminated simply because the stockholders voted it down.  The KKR Group had originally requested a 4% termination fee and a $50 million expense reimbursement provision, but the company was successful in negotiating down from those amounts.

    In addition to the termination fee provision, the merger agreement contained a typical no-shop clause that included a matching right.  It provided that, if a superior proposal surfaced, the KKR Group would have three business days to match that superior proposal.

    Plaintiff stockholders brought suit seeking a preliminary injunction against the closing of the merger.  Plaintiffs also requested that the Court enter the “unusual order combining final relief – invaliding the termination fee and the matching rights in the merger agreement – with preliminary relief – holding off the merger vote for 30 days.”[26]  The Court noted that the plaintiffs requested this relief in order to provide for a period of time for a new bidder to arise, but to ensure that the KKR Group could not walk away from the transaction on the drop dead date.  Refusing to reach plaintiffs’ request that the Court “blue pencil” the merger agreement at this interim stage of the proceedings, the Court considered whether a preliminary injunction was warranted under the facts as presented.  Concluding that the plaintiffs were unlikely to prevail on their claim that the board breached its Revlon duties, the Court refused to grant the preliminary injunction.

    At its core, the plaintiffs request for relief was based on the claim that the directors did not fulfill their Revlon duties.  The Court first noted that the Revlon doctrine is grounded in trust principles that obligate a fiduciary to maximize price for its beneficiaries.  The Court stated that the Revlon doctrine focuses on whether directors, who have decided to sell the corporation, have “undertaken reasonable efforts” to maximize the sale price, but does not require directors to perform “flawlessly.”[27]

    The plaintiffs asserted two primary arguments in support of their contention that the directors failed to satisfy their Revlon duties.  First, the plaintiffs alleged that the directors acted too hastily when they finally decided to accept bids for the entire company.  In particular, the plaintiffs argued that the directors should have opened up the process to new bidders and canvassed the market.  Second, the plaintiffs claimed that the directors “compounded the unreasonableness of its initial process by agreeing to deal protection measures that precluded the emergence of a later, topping bid.”[28]  Although the plaintiffs conceded that the deal protections in the merger agreement allowed for a later bid to emerge, they argued that the “cumulative effect of the termination fee and matching rights created an unreasonably large bidding advantage for the KKR Group that has dissuaded any other bidder from presenting a topping offer.”[29]

    The Court first noted that this case did not present the “paradigmatic context for a good Revlon claim, which is when a supine board under the sway of an overweening CEO bent on a certain direction, tilts the sales process for reasons inimical to the stockholders’ desire for the best price.”[30]  Rather, the Court noted, the present case involved a “majority independent board that publicly initiated a broad search for strategic options to increase shareholder value, ruling out no option.”[31]  As a result, the Court stated, plaintiffs had attempted to “sketch out a picture of a passive board who deferred too easily to the wishes of a CEO . . . and financial advisor.”[32]  According to the plaintiffs, the CEO favored a deal that led to a sale of the entire company because of certain change of control provisions.  In addition, the CEO allegedly favored a deal with the KKR Group because they had offered the best potential for future employment.  The plaintiffs alleged that the financial advisor was interested because it stood to receive an additional $7 million in fees as a result of a sale of the entire company.

    The Court rejected the plaintiffs arguments for three primary reasons.  First, the Court found that the allegations that the CEO and financial advisor had improper motives did not ring true.  Second, the Court found the board process that culminated in the KKR Group’s bid was reasonable.  Finally, the Court concluded that the board’s decision to approve the merger agreement containing the deal protections was reasonable.

    In addressing the allegations made against the CEO, the Court stated that the plaintiffs essentially were accusing the CEO of the “status crime of being a CEO.”[33]  The Court stated that it could not find, on the record before it, that the CEO was “tainted by a personal desire to advantage himself at the expense of the Company’s public stockholders.”[34]  In reaching that decision, the Court was persuaded by certain key facts, including the following:  (i) the CEO negotiated for the removal of provisions for the retention of Toy “R” Us’ management; (ii) the CEO’s compensation from the merger was from his stock and options, so his interests were aligned with the stockholders; (iii) the CEO initiated the strategic process that put his job at risk; (iv) the CEO encouraged a board process for independent directors to consider the merger and for himself to be excluded from certain discussions; (v) the CEO had supported a potential strategic option whereby the company would retain Babies “R” Us without him as CEO; (vi) the CEO supported the plan to sell only Global Toys until the Cerberus Group, not the KKR Group, made a bid for the entire company; (vii) the CEO never discussed his future with any bidder and didn’t tilt the process to any bidder; and (viii) the CEO ultimately did not receive an offer to stay with the company post-merger.[35]

    The Court also concluded that the financial advisor did not tilt the process in favor of the sale of the entire company in order to increase its fees.  Although the financial advisor had a fee arrangement that “was designed to provide an incentive for [the financial advisor] to seek higher value,” the Court noted that the fee arrangement “has been recognized as proper by our courts.”[36]  Moreover, the Court found that the facts did not show that the financial advisor engaged in a “nefarious scheme” to reap a greater fee.[37]  Indeed, the Court found that the financial advisor had supported a sale of only Global Toys for some time.  But the Court criticized the financial advisor for agreeing to provide buy-side financing to the KKR Group and noted that the decision created an unnecessary issue for the financial advisor and its client.  Nevertheless, the Court found no basis to conclude that the decision to provide buy-side financing “ever influenced it to advise the board to sell the whole Company rather than pursue a sale of Global Toys, or to discourage bidders other than KKR, or to assent to overly onerous deal protection measures during the merger agreement negotiations.”[38]

    In addition, the Court concluded that the board’s decision to sell the entire company was the result of a reasonable deliberative process.  Focusing on the length of the process and the public nature of the process, the Court rejected the “swarm of nits” raised by the plaintiffs in regard to the reasonableness of the process.[39]  The Court found that the board could not be faulted for refusing to open up the bidding for the entire company again and for placing a time limit on the final auction process of the “length of the process to date and the risk of losing one of the finalists.”[40]  In reaching that decision, the Court focused on, among other things, the public nature of the process and the sophisticated and aggressive nature of potential bidders for Toys “R” Us.

    The Court also concluded that the Toys “R” Us board did not act unreasonably by agreeing to the deal protections.  The plaintiffs argued that the deal protections precluded other bidders from making a competing offer and supported that allegation with testimony from two professors, R. Preston McAfee and Guhan Subramanian.  The Court noted that the Delaware courts will look “closely at the deal protection measures in merger agreements.  In doing so, we undertake a nuanced, fact-intensive inquiry of the kind recommended [by plaintiffs’ experts].”[41]  The Court indicated that the inquiry is undertaken under the reasonable analysis set forth in Unocal and Revlon, explaining as follows:

That reasonableness inquiry does not presume that all business circumstances are identical or that there is any naturally occurring rate of deal protection, the deficit or excess of which will be less than economically optimal.  Instead, that inquiry examines whether the board granting the deal protections had a reasonable basis to accede to the other side’s demand for them in negotiations. In that inquiry, the court must attempt, as far as possible, to view the question from the perspective of the directors themselves, taking into account the real world risks and prospects confronting them when they agreed to the deal protections.  As QVC clearly states, what matters is whether the board acted reasonably based on the circumstances then facing it.[42]

    The Court found that the plaintiffs’ experts failed to explain what they would have done if they were presented with the choice that the directors faced – two bids, with one being significantly higher than the other.  The Court rejected the arguments that the directors should have haggled more on the termination fee to reduce it even more.  The Court noted that the directors were successful in reducing the fee, and were reasonable in not seeking a further reduction of the fee because of the risk that the purchase price would be reduced or the buyer would walk away.

It is this tradeoff – between getting the highest price the board could from KKR Group right then and there, and the limited opportunity of receiving a higher bid from a well-canvassed market by reducing the termination fee and eliminating the matching rights – which the board and its advisors had to address, and which the plaintiffs and their ivory tower-based experts refuse to realistically engage.[43]

    The Court noted that the deal protections certainly operate “to deter someone who would want to make a bid that is trivially larger than the KKR Group’s bid.  But it is not the concern of our law to set up a system that promotes endless incremental bidding.  To do so risks creating an incentive for lower initial deal prices because initial buyers will have less closing certainty.”[44]  The Court, therefore, concluded that the deal protections were reasonable.  The Court noted that the deal protections will provide a cushion that prevents “small, margin-topping bids. . . .”[45]  But the Court found that “[w]hen that cushion results, as it did here, from a good faith negotiation process in which the target board has reasonably granted these protections in order to obtain a good result for the stockholders, there is no grounds for judicial intrusion.”[46]  The Court continued as follows:

The central purpose of Revlon is to ensure the fidelity of fiduciaries.  It is not a license for the judiciary to set arbitrary limits on the contract terms that fiduciaries acting loyally and carefully can shape in the pursuit of their stockholders’ interest.  Even less is it the purpose of Revlon to push the pricing of sales transactions to the outer margins (or beyond) of their social utility.  If second bidders fear that any move beyond a small topping bid might leave them making an imprudent bid for a public company, it is not clear why our society benefits by encouraging bids of that type or how it would be harmed by their preclusion.  For diversified investors as likely to own the shares of an acquiror as a target, it is often the case that the premium paid in an M & A deal goes from one pocket to another.  For society as a whole, there are real economic and social costs to the acquisition of healthy, profitable companies at an excessive price. Creditors, consumers, workers, and communities can suffer when that happens.  If the marginal cost to a second bidder of the difference between a 2.5% termination fee without matching rights and a 3.75% termination fee with matching rights really raises a reasonable concern that any material higher bid would be economically irrational, then that suggests that the board got close to the Company’s maximum economic value, when measured by fundamental measures of its earning power.

This is not to say that this court is, or has been, willing to turn a blind eye to the adoption of excessive termination fees, such as the 6.3% termination fee in Phelps Dodge that Chancellor Chandler condemned, that present a more than reasonably explicable barrier to a second bidder, or even that fees lower than 3% are always reasonable.  But it is to say that Revlon’s purpose is not to set the judiciary loose to enjoin contractual provisions that, upon a hard look, were reasonable in view of the benefits the board obtained in the other portions of an integrated contract.[47]

    Finally, the Court found that the plaintiffs failed to show a serious threat of irreparable harm or that the balance of the equities favored a preliminary injunction.  On the issue of irreparable harm, the Court noted that the plaintiffs themselves were not presenting a topping bid, and therefore they suffered no harm of losing an opportunity to bid for the company, but only “face[d] the loss of dollar value from the theoretical possibility that the deal protections have precluded a topping bid.”[48]  The Court, therefore, noted that appraisal would be an appropriate remedy for the plaintiffs.  On the issue of balancing the equities, the Court noted that the plaintiffs had already sold a large number of their shares in the market and therefore they were not in “a high ground position to put at risk the opportunity for other Company stockholders to vote to accept that northerly price.”[49]  Finally, the Court noted that the stockholders ultimately have the final say on the merger and, if they believe the price was not high enough, could vote against its approval.

    The Toy “R” Us decision confirms that, in the absence of coercive or preclusive deal protection provisions, Delaware courts generally will not apply bright-line rules when determining whether a board has acted reasonably.  The primary lesson learned from Toys “R” Us is that boards considering a sale of part or all of the company should hire advisors at an early stage and structure a process that demonstrates a careful, deliberative and engaged analysis of the various alternatives and risks.  With a properly structured process, a plaintiff will have a difficult time attacking a board’s decision on reasonableness grounds even under the heightened standard of proof mandated by Revlon.

III. The Special Committee Process and Fairness Opinions: TCI

    On December 21, 2005, the Court of Chancery rendered a decision in In re Tele-Communications, Inc. Shareholders Litigation,[50] denying defendants’ motion for summary judgment on several claims challenging the merger of Tele-Communications, Inc. with AT&T Corp., consummated in March of 1999.  Among other things, the decision highlights the importance of designing and implementing an effective special committee process in order to accomplish a shift in the burden of proving entire fairness, especially where that committee is confronted with the challenging task of considering a transaction that envisions the payment of a premium to a class or series of high-vote stock over that to be paid to a class or series of low-vote stock.

    At issue in TCI was the treatment of two series of common stock:  Series A TCI Group Common Stock (the “Series A shares”) and Series B TCI Group Common Stock (the “Series B shares”).  The Series A shares were entitled to one vote per share, while the Series B shares were entitled to ten votes per share.  Otherwise, the Series A shares and the Series B shares had identical terms.  When discussions began between TCI and AT&T concerning a proposed merger, John Malone, TCI’s Chairman and Chief Executive Officer, insisted that he would approve the transaction as a TCI stockholder only if the Series B shares received a premium of ten percent over the Series A shares.  Malone and four other TCI directors, collectively constituting a majority of the nine member TCI board, owned 84% of all of the outstanding Series B shares.

    The TCI board formed a special committee to consider the proposed merger.  The special committee was comprised of two members:  Paul A. Gould, an owner of a significantly larger number of Series B shares than Series A shares, and John W. Gallivan.  Before the special committee’s deliberations commenced, the TCI board approved a plan to reasonably compensate the committee members for their service, but did not specify either an amount or a formula for determining the compensation.  The special committee met four times over a five day period.  The special committee did not hire its own independent financial advisors or legal counsel, but relied on TCI’s financial and legal advisors.  TCI’s financial advisor informed the special committee of precedent transactions where high-vote stock had received a premium to low-vote stock, but noted that those transactions were “less common” than transactions where no premium was paid.  TCI’s financial advisor also opined on the fairness of the merger consideration to each of the Series A shares and the Series B shares, respectively.

    After receiving that advice, the special committee recommended the merger to the full TCI board and it was approved.  Several months later, TCI stockholders overwhelmingly approved the merger. Immediately prior to the stockholder approval, the special committee members were each paid $1 million for their committee service.  As a result of their ownership of the Series B shares, a majority of the directors received, in the aggregate, $376 million more than they would have received if no premium had been paid and the shares were treated equally.  Malone obtained the highest benefit from the premium, receiving in excess of $100 million more than he would have received if there were no premium, while the director obtaining the lowest benefit from the premium received in excess of $500,000 more than he would have received if there were no premium.

    Plaintiff stockholders brought several claims challenging the merger.  In rejecting defendants’ motion for summary judgment on certain of those claims, the Court initially concluded that the relevant standard of review was entire fairness.  Citing FLS Holdings[51] and Reader’s Digest,[52] the Court found that entire fairness should apply because “a clear and significant benefit . . . accrued primarily . . . to [] directors controlling [] a large vote of the corporation, at the expense of another class of shareholders to whom was owed a fiduciary duty.”[53]  In the alternative, the Court concluded that a majority of the TCI directors were interested in the transaction because they each received a material benefit from the Series B shares premium.

    After concluding that the transaction would be reviewed under the entire fairness standard, the Chancellor, drawing all reasonable inferences in favor of the plaintiffs for purposes of deciding the summary judgment motion, found that the creation and use of the special committee had failed to shift the burden of proof under that standard.  The Chancellor determined that the record contained a genuine issue of material fact as to whether the special committee was truly independent, fully informed and vested with the freedom to negotiate at arm’s length.

    On the question of independence, the Court stated that that Gould’s holdings of Series B shares, which provided him with an additional $1.4 million as a result of the premium paid on the Series B shares, and the “suspiciously contingent compensation of the Special Committee…sufficiently impugn the independence of the Special Committee to prevent any burden shifting.”

    The Court then examined the special committee process under the entire fairness standard.  The Chancellor concluded that it could not conclude on summary judgment that the merger was entirely fair because genuine issues of material fact remained relating to fair dealing and fair price.  Accordingly, the Chancellor denied defendants’ motion for summary judgment.

    In reaching the decision that the defendants failed to demonstrate fair dealing and fair price, the Court found, based on a review of the evidence in a light most favorable to the plaintiffs, the following special committee process flaws:

The special committee was tainted with an interested director.  The TCI board selected Gould, who held Series B shares and gained an additional $1.4 million as result of the premium paid on those shares, to serve on the special committee.  There was no explanation for why the TCI board did not select, in place of Gould, one of the other directors, who held only Series A shares.  This flaw appears to be of primary importance to the Court’s decision and contributed to each of the other flaws in the committee process.

The special committee did not have a clear mandate.  Gallivan believed the special committee’s job was to represent the interests of the holders of the Series A shares, while Gould believed the special committee’s job was to protect the interests of all of the stockholders.

The special committee should have retained its own advisors.  The special committee did not retain separate legal and financial advisors, and chose to use the TCI advisors.  Moreover, the Court criticized the contingent nature of the fee paid to the financial advisor, which amounted to approximately $40 million, finding that such a fee created “a serious issue of material fact, as to whether [the financial advisor] could provide independent advice to the Special Committee.”  While the Court agreed with Malone’s assertion that TCI had no interest in paying such compensation absent a deal, “[a] special committee does have an interest in bearing the upfront cost of an independent and objective financial advisor.”  It is important to point out, however, that the advisors were hired to advise TCI in connection with the transaction, and a question arises as to whether the Chancellor’s concerns about the contingent nature of the fee would have been mitigated if a special committee comprised of clearly disinterested and independent directors hired independent advisors and agreed to a contingent fee that created appropriate incentives.

The special committee did not conduct sufficient due diligence or analysis of the pricing.  The special committee lacked complete information about the premium at which the Series B shares historically traded.  The Court noted that the plaintiffs had presented evidence that showed that the Series B shares had traded at a 10% premium or more only for “a single five-trading day interval.”  The Court did not find it persuasive that the financial advisor supported the payment of the premium by reference to a call option agreement between Malone and TCI that allowed TCI to purchase Malone’s Series B shares for a 10% premium, expressing concern about the arm’s length nature of that transaction.  In addition, the special committee lacked complete information about the precedent transactions.  The Court stated that the special committee should have asked the financial advisor for more information about the precedent transactions, including information concerning the prevalence of the payment of a premium to high-vote stock over low-vote stock.  By contrast, the Court noted that the plaintiffs had presented evidence suggesting that a significantly higher number of precedent transactions provided no premium for high-vote stock.

The fairness analysis and the fairness opinion did not provide the special committee with all of the relevant information.  One of the most significant parts of the Court’s analysis for corporate practitioners was the Chancellor’s focus on the nature of the fairness opinion delivered by the financial advisor.  While the financial advisor did conduct a separate analysis of the fairness of the price to be paid to each class, the financial advisor’s opinion did not “discuss the effect of the [Series B shares] premium upon the [Series A] holders, i.e., whether the [] premium was fair to the [Series A] holders.”  The Court stated that the Reader’s Digest decision “appears to mandate exactly such an analysis:  that the relative impact of a preference to one class be fair to the other class.”  The Court noted that the Reader’s Digest decision “mandated more than separate analyses that blindly ignore the preferences another class might be receiving, and with good intuitive reason:  such a doctrine of separate analyses would have allowed a fairness opinion in our case even if the [Series B] holders enjoyed a 110% premium over the [Series A] holders, as long as the [Series A] holders enjoyed a thirty-seven percent premium over the market price.”  The Court found that the plaintiffs had “presented sufficient evidence of the historical [Series B shares] premium and comparable precedent high-vote stock premiums to demonstrate a triable issue with respect to the fairness of the [] premium to the [Series A] holders.”

All of the above factors led to a flawed special committee process that created an “inhospitable” environment for arm’s length bargaining.  The Court found that the unclear mandate, the unspecified compensation plan and the special committee’s lack of information regarding historical trading prices of the Series B shares and the precedent merger transactions were relevant to concluding that the process did not result in arm’s length bargaining.

    The TCI decision reaffirms the importance of designing and implementing an independent and effective special committee process where a transaction is likely to be adjudicated under the entire fairness standard.  In addition to the obvious need to appoint to a special committee only members who are not tainted by interest, the decision highlights the concomitant needs to:  (i) establish the compensation of committee members in advance, (ii) provide the special committee with a clear mandate, (iii) allow and encourage the special committee to hire independent financial advisors and legal counsel; (iv) structure the advisors’ compensation so as to minimize their incentive to favor any particular deal, and (v) generally encourage a process that results in arm’s length bargaining.

    Of particular importance to corporate practitioners, the TCI decision suggests that a special committee charged with considering a transaction that provides a premium to a high-vote stock over a low-vote stock should ensure that it demands and considers all information reasonably available to it and relevant to the fairness of the proposed premium and, in that regard, that it should request a fairness opinion focused on the low-vote stock in an effort to allow the special committee to evaluate not only the fairness of the merger consideration to each class or series separately, but also the fairness of the merger consideration to the low-vote stock in light of any premium paid on the high-vote stock.

    We note that, as a practical matter, it may be difficult to obtain a fairness opinion from a financial advisor that addresses that issue.  Despite the Court’s decision in Reader’s Digest, financial advisors have remained reluctant to provide opinions comparing the value of consideration received by separate classes or series.  It remains to be seen whether the TCI decision will lead to a strong enough demand by special committees as to encourage financial advisors to offer such opinions more freely.  Notwithstanding this practical obstacle, however, the TCI decision leaves no doubt, however, that special committees must focus on the differing treatment of classes and series of shares of stock and obtain all relevant information to evaluate that differing treatment.  Even if the special committee is unsuccessful in receiving a written fairness opinion, it therefore should, at the very least, secure oral advice from the financial advisor sufficient to enable the special committee to make an informed decision about the fairness of the consideration.

IV. Agreement to Submit Rights Plan to Stockholder Vote: Unisuper

    The Court of Chancery also recently considered whether a corporation could be deemed contractually bound to its stockholders to submit the extension of a stockholder rights plan to a stockholder vote. In Unisuper Ltd. v. News Corporation,[54] an Australian corporation, News Corporation (“News Corp.”), announced a plan of reorganization that included the reincorporation of the corporation from Australia to Delaware.  The reorganization and reincorporation was contingent upon a separate class vote of each class of the corporation’s capital stock.

    After the announcement, Australian Council of Super Investors, Inc. (“ACSI”), a non-profit organization that provides advice to Australian pension funds, and Corporate Governance International (“CGI”), an Australian proxy advisory firm, met with News Corp. to discuss their concerns with the reincorporation and its effect on stockholder rights and various additional corporate governance issues.  Among other things, ACSI and CGI expressed concern that Australian law required a stockholder vote before a corporation could adopt a stockholder rights plan, while Delaware law contained no such mandate.  ACSI and CGI ultimately drafted proposed changes to be included in the corporation’s charter to address their concerns. After initially rejecting those changes, News Corp. realized that stockholder opposition to the reorganization and reincorporation was increasing.  It therefore began negotiations with ACSI and CGI in an effort to address their concerns.

    The negotiations centered upon five key issues, three of which ultimately led to revisions to the Delaware charter, while one was enshrined in a voting agreement with the controlling stockholder.  The fifth key issue, the ability to adopt a poison pill without a stockholder vote, was addressed in a board policy (the “Board Policy”) after News Corp. rejected the inclusion of a provision in the charter.  Thus, News Corp. announced that the “Board ha[d] adopted a policy that if a shareholder rights plan is adopted by the Company following reincorporation, [it] would have a one-year sunset clause unless shareholder approval is obtained for an extension.”[55]  The Company also noted that the policy provided that if stockholder approval was not obtained, the Company would not adopt a successor stockholder rights plan having substantially the same terms and conditions.

    On October 26, 2004, the stockholders of News Corp. voted to approve the reorganization and the corporation was reincorporated in Delaware.  On November 8, 2004, a prospective hostile acquiror made its intentions known to News Corp.  In response, the News Corp. board immediately adopted a rights plan, and announced that the corporation “might or might not implement the Board Policy depending on whether it deemed the policy ‘appropriate in light of the facts and circumstances existing at such time.’”[56]  A year later, the News Corp. board extended the stockholder rights plan without seeking a vote of the stockholders.

    A group of Australian investors commenced an action seeking to enforce the Board Policy.  The plaintiffs asserted five claims:  (i) breach of contract, (ii) promissory estoppel, (iii) fraud, (iv) negligent misrepresentation and equitable fraud, and (v) breach of fiduciary duties.  The plaintiffs sought relief in the form of a judgment declaring the rights plan invalid, and an injunction to prevent News Corp. from extending the rights plan without stockholder approval.  The defendants moved to dismiss the plaintiffs’ claims.

    The Court dismissed all of the claims except for the breach of contract and promissory estoppel claims.  In refusing to dismiss the breach of contract claim, the Court first concluded, although expressing some skepticism, that the plaintiffs had sufficiently alleged the existence of either an oral or written contract to submit the extension of a rights plan to a stockholder vote.  The Court then addressed the defendants’ argument that, even if a contract existed, the contract would be unenforceable as a matter of law.  To support that argument, the defendants contended that any such contract is contrary to Section 141(a) of the General Corporation Law of the State of Delaware (“Section 141(a)”), which charges a board of directors with the obligation to manage the business and affairs of a Delaware corporation absent a contrary charter provision.  Thus, the defendants argued that the contract, which purports to limit the board’s ability to manage the business and affairs of the corporation, is invalid because it is not in the corporation’s charter.

    The Court rejected that argument noting, among other things, that any contract a board enters into could be deemed to limit the board’s power and thus be invalid.  The Court reasoned that Section 141(a) does not prohibit a board from entering into a contract that limits its powers, but merely prohibits a board from “ceding that power to outside groups or individuals.”[57]  The Court found that the “fact that the alleged contract in this case gives power to the shareholders saves it from invalidation under Section 141(a).  The alleged contract with ACSI did not cede power over poison pills to an outside group; rather, it ceded that power to shareholders.”[58]  The Court reasoned that, although Delaware law empowers the board to manage the business and affairs of the corporation, “when shareholders … exercise control over the business and affairs of the corporation the board must give way.  This is because the board’s power – which is that of an agent’s with regard to its principal – derives from the shareholders, who are the ultimate holders of power under Delaware law.”[59]

    The Court also rejected the defendants argument that the Delaware Supreme Court decisions in QVC,[60] Quickturn[61] and Omnicare[62] supported the view that the contract is unenforceable as a matter of law.  In particular, the Court noted that those cases were different because they “invalidated contracts the board used in order to take power out of shareholders’ hands.”[63]

    In QVC and Quickturn, the contracts at issue “were defensive measures that took the power out of the hands of shareholders.”[64]  Thus, the Court reasoned as follows:

The contracts raised the “omnipresent specter” that the board was using the contract provisions to entrench itself, i.e., to prevent shareholders from entering into a value-enhancing transaction with a competing acquiror.  In this case, the challenged contract put the power to block or permit a transaction directly into the hands of shareholders.  Unlike in Paramount and Quickturn, there is no risk of entrenchment in this case because shareholders will make the decision for themselves whether to adopt a defensive measure or leave the corporation susceptible to takeover.[65

    In Omnicare, the Delaware Supreme Court determined that an agreement by the board to submit a merger agreement to a stockholder vote was unenforceable because it “resulted in the board disabling its ability to exercise its fiduciary duties to the minority shareholders.”[66]  The Court found that the Delaware Supreme Court’s ruling in Omnicare did not support the invalidation of the agreement at issue.  The Court reasoned as follows:

Unlike the board in Omnicare, the News Corp. board entered into a contract that empowered shareholders; it gave shareholders a voice in a particular corporate governance matter, viz., the poison pill.  It makes no sense to argue that the News Corp. board somehow disabled its fiduciary duties to shareholders by agreeing to let the shareholders vote on whether to keep a poison pill in place.  This argument is an attempt to use fiduciary duties in a way that misconceives the purpose of fiduciary duties.  Fiduciary duties exist in order to fill the gaps in the contractual relationship between the shareholders and directors of the corporation.  Fiduciary duties cannot be used to silence shareholders and prevent them from specifying what the corporate contract is to say.  Shareholders should be permitted to fill a particular gap in the corporate contract if they wish to fill it.  This point can be made by reference to principles of agency law:  Agents frequently have to act in situations where they do not know exactly how their principal would like them to act.  In such situations, the law says the agent must act in the best interests of the principal.  Where the principal wishes to make known to the agent exactly which actions the principal wishes to be taken, the agent cannot refuse to listen on the grounds that this is not in the best interests of the principal.

To the extent defendants argue that the board’s fiduciary duties would be disabled after a hypothetical shareholder vote, this argument also misconceives the nature and purpose of fiduciary duties.  Once the corporate contract is made explicit on a particular issue, the directors must act in accordance with the amended corporate contract.  There is no more need for the gap-filling role performed by fiduciary duty analysis.  Again, the same point can be made by reference to principles of agency law:  Where the principal makes known to the agent exactly which actions the principal wishes to be taken, the agent must act in accordance with those instructions.[67]

    In response to the Court of Chancery’s decision, the defendants sought certification of an interlocutory appeal to the Delaware Supreme Court.  The Court of Chancery issued an order certifying the interlocutory appeal, using the opportunity to dilate on the context-related limitations of its initial opinion.[68]  The Court highlighted the fact that it had expressed “great skepticism” with respect to whether a binding contract actually came into existence between the stockholders and News Corp., and had proceeded under the assumption that a contract was created because “defendants have conceded that there was a contract.”[69]

    The Court also addressed its reasoning on the Section 141(a) and fiduciary duty arguments.  With respect to the Section 141(a) argument, the Court took issue with the suggestion that a board may never limit its powers through contract.  The Court noted that a holding that a “board may never limit its power through contract would, in my opinion, have the unintended effect of severely limiting the board’s power to manage the business and affairs of the corporation,[70] offering as examples a board’s decision to enter into merger agreements containing deal protections and settlement agreements that require it to undertake therapeutic corporate governance action in the future.

    With respect to the fiduciary duty argument, the Court clarified its reliance upon agency principles when concluding that the purported contract at issue was different from other contracts that had been invalidated by the Delaware courts.  The Court made it clear that it was not creating a new paradigm for understanding Delaware law, but had simply utilized agency principles in response to the attempted use of fiduciary duty principles “as a sword for directors to use against shareholders as a group.”[71]  The Court noted that there may be circumstances where fiduciary duties might require a board to prevent a stockholder vote from occurring, such as when there is a risk of improper coercion.  But the Court explained that those circumstances were not before it.

On its face, a shareholder vote on whether or not to keep in place a poison pill, or a vote on amending the company’s charter to prohibit adoption of a poison pill, is not a vote, to my mind, that raises the specter of improper coercion.[72]

The Delaware Supreme Court, in an order issued on January 27, 2006, refused to accept the appeal.[73]

    In light of the reasoning in the Court of Chancery’s order certifying the appeal, it is apparent that practitioners should not rely in too literal way upon the reasoning of the Court of Chancery’s opinion on the motion to dismiss.  Although it is possible that a corporation may bind itself, in certain circumstances, to submit a matter to a stockholder vote, the burden of proving that an agreement has in fact been established may be difficult.  Moreover, the Court of Chancery significantly qualified its reliance on agency principles.  Practitioners should not, therefore, read the Court of Chancery’s decision as a blank check to support an argument that a board of directors, as agents, must always submit to the will of its stockholders, as principals, without regard to the board’s fiduciary duties or the requirements of Section 141(a).

V. The Internal Affairs Doctrine and the California Corporations Code:  Examen

    In VantagePoint Venture Partners 1996 v. Examen, Inc.,[74] the Delaware Supreme Court took up the question of whether the California Corporations Code applied to Delaware corporations that are deemed to be quasi-California corporations under Section 2115 of the California Corporations Code.[75]  At issue in Examen was whether the holders of Series A Preferred Stock of Examen, Inc. (“Examen”), a Delaware corporation, were entitled to a class vote on a merger.  On March 3, 2005, Examen filed an action in the Court of Chancery seeking a judicial declaration that no class vote was required under either the General Corporation Law of the State of Delaware or the Certificate of Designations of the Series A Preferred Stock of Examen.

    On March 8, 2005, VantagePoint Venture Partners, Inc. (“VantagePoint”), a holder of Series A Preferred Stock of Examen, filed an action in the California Superior Court seeking, among other things, a declaration that Examen was a quasi-California corporation under the California Corporations Code, and, as a result, a class vote of the Series A Preferred Stock was required to approve the merger.  On March 10, 2005, the Delaware Court of Chancery granted Examen’s request for an expedited hearing on its motion for summary judgment.  Following a stay of the California action, the Delaware Court of Chancery ruled on March 29, 2005 that the issue was governed by the internal affairs doctrine and that a class vote was not required under Delaware law.  VantagePoint appealed that ruling and soon thereafter requested that the Delaware Supreme Court enjoin the merger.  The Delaware Supreme Court refused and the merger was consummated on April 5, 2005.

    In the lower court decision, the Court of Chancery determined that the question was governed by the internal affairs doctrine.  The Court of Chancery addressed VantagePoint’s argument that Section 2115 of the California Corporations Code did not conflict with Delaware law because it “operated only in addition to rights granted under Delaware corporate law.”  In rejecting that argument, the Court pointed out that Section 2115 of the California Corporations Code specifically states that “it operates ‘to the exclusion of the law of the jurisdiction in which [the corporation] is incorporated.’”[76]  The Court found that the issue was simply one of choice of law and did not address the constitutional argument proffered by the litigants.  Thus, the Court concluded that Section 2115 of the California Corporations Code conflicted with Delaware law on the stockholder vote question, and found that Delaware law controlled.

    In its appeal to the Delaware Supreme Court, VantagePoint argued that the question was not simply one of choice of law. Rather, VantagePoint contended that a constitutional question was at issue – i.e., “whether California may promulgate a narrowly-tailored exception to the internal affairs doctrine that is designed to protect important state interests.”[77]  VantagePoint argued that the statutory section merely provided an additional layer of statutory protections only for certain corporations that have significant contacts with California, and thus operates much like the rules and regulations of stock exchanges.  Accordingly, VantagePoint contended that the Delaware Supreme Court must either apply the statute or find that it is unconstitutional.

    The Delaware Supreme Court reviewed the Court of Chancery’s decision de novo and ultimately affirmed its decision.  In reaching its decision, the Court found that the internal affairs doctrine was not simply a conflict of laws principle,[78] but was mandated by constitutional principles.  In particular, the Court noted that directors, officers and stockholders have the right, under the Due Process Clause of the Fourteenth Amendment, to know what law will govern the affairs of the corporation.  The Court observed in addition that, under the Commerce Clause, no state has an interest in regulating foreign corporations.  Based on those principles, the Court found that the internal affairs doctrine will apply, except in rare situations, such as “when ‘the law of the state of incorporation is inconsistent with a national policy on foreign or interstate commerce.’”[79]

    The Court then rejected an argument by VantagePoint that Section 2115 of the California Corporations Code simply was a “limited exception to the internal affairs doctrine.”[80]  The Court noted that the California statute generates uncertainty because the question of whether a corporation satisfies the statutory prerequisites may vary from year to year, leading to confusion about what state law governs the corporation at any given time.  The Court concluded that “[t]o require a factual determination to decide which of two conflicting state laws governs the internal affairs of a corporation at any point in time, completely contravenes the importance of stability within inter-corporate relationships that the United States Supreme Court recognized in CTS.”[81]

    With these principles in mind, the Court pointed out that the Court of Chancery has applied the internal affairs doctrine and “recognized that Delaware courts must apply the law of the state of incorporation to issues involving corporate internal affairs, and that disputes concerning a shareholder’s right to vote fall squarely within the purview of the internal affairs doctrine.”[82]  Relying upon the United States Supreme Court decision in CTS, the Court found that (i) Examen was a Delaware corporation and (ii) the legal issue, whether a class vote was required, “clearly involves the relationship among a corporation and its shareholders.”  Thus, the Court concluded as follows:

[W]e hold Delaware’s well-established choice of law rules and the federal constitution mandated that Examen’s internal affairs, and in particular VantagePoint’s voting rights, be adjudicated exclusively in accordance with the law of its state of incorporation, in this case, the law of Delaware.[84]

    The Court also rejected an argument by VantagePoint that the Court will encourage forum shopping races to the courthouse by refusing to apply the California Corporations Code to Examen.  In particular, VantagePoint contended that if it had filed in California first, it could have obtained an injunction against the merger.  The Court pointed out that the case upon which VantagePoint primarily relied was decided prior to the United States Supreme Court decision in CTS and the Delaware Supreme Court’s decision in McDermott.  The Court concluded that it adhered to the views expressed in a prior decision that “after the Kamen and CTS holdings by the United States Supreme Court, the California courts would ‘apply Delaware . . . law [to the internal affairs of a Delaware corporation], given the vitality and constitutional underpinnings of the internal affairs doctrine.’”[85]

    Although the decision in Examen is a strong statement by the Delaware Supreme Court that Delaware law governs the internal affairs of a Delaware corporation, it is unclear to what extent courts in other jurisdictions will reach a similar conclusion.  Even after Examen, therefore, practitioners have continued to tread carefully when considering transactions involving a corporation that might be deemed to be a quasi-California corporation.  When the California Corporations Code potentially is implicated, it remains advisable to structure a transaction, as best as possible, to adhere to the statutory mandates of both the General Corporation Law of the State of Delaware and the California Corporations Code.

CONCLUSION

    The law continues to develop in Delaware on a variety of fronts that are of particular interest to corporate practitioners.  The decision in Disney II has reassured many practitioners that the business judgment rule remains alive and well in Delaware, while more clearly defining the duty of good faith.  The Court of Chancery has confirmed in Toys “R” Us that it will engage in a context specific analysis of the reasonableness of deal protections in merger agreements.  In TCI, the Delaware Court of Chancery sent a clear message with respect to the importance of running an effective special committee process and the need for that committee to receive the proper advice from its financial advisor.  Moreover, the Delaware Court of Chancery in Unisuper suggested that when a Delaware corporation enters into a contract with its stockholders to submit a rights plan to a stockholder vote, it will be difficult for directors to argue that their fiduciary duties deny stockholders those voting rights.  Finally, in Examen, the Delaware Supreme Court confirmed that the Delaware courts will not apply the California Corporations Code to a quasi-California corporation incorporated in Delaware.

Notes