Corporate boards and their lawyers breathed a collective sigh of relief March 25 when an en banc Delaware Supreme Court reversed a ruling many feared could expose directors to personal liability in M&A deals.
The facts of the case date back to April 2006, when Dutch chemical company Basell expressed interest in acquiring Lyondell Chemical Co. That was followed in May 2007 by an unsolicited offer from Basell. By July, the parties had negotiated to a price of $48 per share of Lyondell stock--but the offer came with a one-week window. Lyondell accepted and its shareholders sued, characterizing the board's consideration of the bid as whirlwind. Courts allowed the merger to go forward (it was completed in late 2008), and the shareholders pursued damages from the directors for breaching their fiduciary duties by greenlighting the deal. Their claims applied the test of the fiduciary duty of good faith to the M&A context.
When the Delaware Court of Chancery denied summary judgment to Lyondell, some thought it was opening the door for more shareholder claims by lowering the bar for bad faith in M&A deals and hinting that boards must follow some prescribed chain of action in deal-making.
But the latest ruling from the state Supreme Court shut down the possibility, reversing the chancery decision and affirming that bad faith is going to be hard for plaintiffs to prove--just as the courts have ruled in other business situations. Many believe the standard for proving bad faith that Lyondell affirms--set forth in Delaware, the breeding ground for corporate law development--will insulate directors in M&A deals from shareholder bad faith allegations absent any conflicts of interest.
"The decision gives support to directors who have to make these tough calls about how to sell a company ... and makes clear that Delaware courts are not going to go back and second-guess the directors' decisions so long as there were not conflicts of interest at issue," says Steven Haas, an associate at Hunton & Williams.
Bad Faith Backstory
Delaware common law dictates that to satisfy their fiduciary duties, directors must act on an informed basis, in good faith and in the honest belief that their actions are in the best interest of the company.
"'Informed basis' is easy; that's the duty of care," says Eric Chiappinelli, dean and law professor at Creighton University School of Law. "The third prong is also relatively clear--that's the duty of loyalty. And so the question is, what does it mean to act in good faith or, on the flip side, bad faith?"
Two 2006 Delaware cases provided guidance and context for the Lyondell case. In re The Walt Disney Co. Derivative Litigation established that bad faith is a legitimate claim but declined to clarify whether it is a separate duty. The Delaware Supreme Court cleared things up a few months later in Stone v. Ritter, establishing that the good faith/bad faith issue lies within the duty of loyalty--in other words, that good faith is a necessary component of loyalty.
Most stockholder allegations in M&A transactions--as in Lyondell--go after the failure of the directors to adequately shop the company and reach out to potential buyers.
"Those allegations really sound like negligence claims," Haas says. "[But] we've seen a recent trend of plaintiffs who are starting to allege that the directors in fact knew that they weren't adequately shopping the company and knew that they weren't getting the best price reasonably available. And they were essentially repackaging these duty-of-care claims as bad faith claims."
There's a reason why the Lyondell shareholders sued on a bad faith rather than a negligence/duty-of-care claim: Among the many corporate-friendly laws in the Delaware General Corporation Law is a provision allowing companies to place exculpatory clauses in corporate charters to shield their directors from personal liability for failure to exercise due care. However, the provision does not allow the same protection for failing to satisfy their duty of loyalty--and thus, bad faith claims are exempt from exculpation. In response, shareholders and plaintiffs lawyers identified the good faith test area as a place to push.
"A lot of these cases came up in a procedural state where the factual record hadn't been really developed, so the courts were talking about what might be the case, and letting them go forward," says Carl Reisner, co-head of the M&A group at Paul, Weiss, Rifkind, Wharton & Garrison. "And the lower court in Lyondell added to the concern that a line of attack was opening up in the M&A context in the good faith/bad faith area."
The Supreme Court's ruling in Lyondell quashed those fears. Justice Carolyn Berger's opinion sets aside personal liability for independent and disinterested directors in M&A deals unless there has been a "conscious disregard" of duty or if the directors "utterly failed to attempt to obtain the best sales price."
"[The case] doesn't really change the advice [I will give] to companies, but it does change the judicial focus on review from the question 'Did the directors do everything they could have done?' to 'Was there an utter failure to seek to obtain the best price?'" Reisner says.
Borrowed from the landmark 1996 Delaware case In re Caremark International Inc. Derivative Litigation, the "utterly failed" wording sets a high bar. Caremark established that directors can be held liable for failure of oversight only in the event of an "utter failure to attempt to ensure" legal compliance. The opinion also noted that bad faith is "possibly the most difficult theory in corporation law upon which a plaintiff might hope to win a judgment."
Haas points out that since Caremark set such a high standard, only one or two cases have ever overcome a motion to dismiss on failure-of-oversight claims. He expects the appropriated language in the Lyondell decision to have a similar effect.
"To set such a high standard was surprising to me because with that standard in mind, it's almost impossible to conceive of a situation where directors who are independent and disinterested could be held liable," Haas says.
Haas believes it's unlikely that shareholders will continue to pursue such bad faith claims in M&A transactions following Lyondell. "It's simply too hard to prove," he says, predicting that shareholders instead will increasingly challenge disclosure violations and pursue injunctive relief based on a breach of the duty of care.
What's clear is that shareholder activism is rising, and Lyondell doesn't change that. The Delaware State Bar Association is currently considering proposed amendments to the Delaware General Corporation Law to submit to the Delaware General Assembly. The changes could significantly increase shareholders' rights. Similar discussions about corporate democracy are taking place in the SEC.
"One could say that the right way for the law to go in general is to improve the ability of corporate democracy to improve the functioning of the ballot box, to have real accountability in elections for directors and to have stockholders policing their companies rather than using litigation to police that," Reisner says.
Lyondell falls in line with that idea, and also supports the trend that shareholders aren't the only ones becoming more active.
"Today directors are becoming increasingly more active, and they're moving away from a rote check-the-box mentality and getting increasingly more involved in making substantive decisions," Haas says. "That's a very good thing in corporate governance."
Corporate boards can take heart that Lyondell goes a long way toward allowing them to make those well-informed business decisions without the threat of personal liability.