September 12, 2008

Delaware Chancellor Dismisses Claim that Directors Sold Subsidiary in Bad Faith

From Travis Laster: In McPadden v. Sidhu, Delaware Chancellor Chandler recently granted a motion to dismiss claims against the outside directors of i2 Corporation for allegedly selling a significant subsidiary in bad faith. The decision merits close attention both substantively for what the Chancellor views as exculpated conduct under Section 102(b)(7) and procedurally for its approach to Rule 23.1.

The Facts

According to the allegations of the complaint, the directors of i2 approved the sale of one of i2’s subsidiaries, TSC, to Anthony Dubreville, an officer of i2, for $3 million. Six months later, Dubreville received a third party offer for TSC for $18.5 million. Two years later, Dubreville sold TSC for $25 million. The board delegated to Dubreville the task of running the sale process for TSC despite knowing that he was interested in acquiring TSC via an MBO. The Board relied on Dubreville to convey information about TSC to potential purchasers, and also relied on him for information about expressions of interest. No business broker or investment banker was hired. At the time of the purchase, a competitor allegedly had expressed interest in acquiring TSC for $25 million.

Taking these allegations as true for purposes of his ruling, the Chancellor first denied the defendants’ motion to dismiss pursuant to Rule 23.1, finding that “plaintiff has pleaded a duty of care violation with particularity sufficient to create a reasonable doubt that the transaction at issue was the product of a valid exercise of business judgment.” (17). Under the second prong of Aronson, therefore, demand was futile. The Court observed that it was grossly negligent for directors to task Dubreville with leading the sale process when the board knew he was interested in buying the subsidiary. The board then “engaged in little or no oversight of that sale process, providing no check on Dubreville’s half-hearted (or, worse, intentionally misdirected) efforts in soliciting bids for TSC.” (19).

Dubreville did not contact natural buyers, such as TSC’s competitors, and he did not contact the party that had expressed interest in a purchase for $25 million. The board was provided with information about the selective process and knew what Dubreville had done, but did nothing to remedy the situation. Instead they approved a sale to Dubreville. The directors also did not take into account the fact that the sale price was below the range of fair value calculated using projections prepared for potential buyers in January 2005, and only barely within the range of fairness based on revised projections prepared by Dubreville’s buy-side management team in February 2005. Based on all of these issues, the Chancellor found it “obvious” that the directors were grossly negligent. (22).

Despite denying the Rule 23.1 motion, the Chancellor dismissed the claims against the outside directors for failure to state a claim in light of the Section 102(b)(7) provision in i2’s charter. The plaintiff argued that the allegations regarding the directors’ conduct were sufficient to state a claim for breach of the duty of loyalty based on action taken in bad faith. The Chancellor, however, interpreted the Delaware Supreme Court’s holding in Stone v. Ritter as holding that bad faith requires some form of intentional action, namely “the intentional dereliction of duty or the conscious disregard for one’s responsibilities.” (25). This left conduct that involves “reckless indifference to or a deliberate disregard of the whole body of stockholders or actions which are without the bounds of reason” as falling under the heading of gross negligence and hence involving only a care breach. (24). The Chancellor held that the defendant directors’ actions “are properly characterized as either recklessly indifferent or unreasonable.” (26). Such conduct, however, gave rise to a breach of the duty of care and was exculpated under Section 102(b)(7).

The Chancellor then turned to Dubreville himself. He first held that “an officer owes to the corporation identical fiduciary duties of care and loyalty as owed by directors.” (27). Officers, however, are not protected by Section 102(b)(7). The Chancellor held that the complaint “more than sufficiently alleged a breach of fiduciary duty.” (28). The Chancellor also held that the plaintiff had adequately alleged that Dubreville had been unjustly enriched by his misconduct.


Several aspects of McPadden are noteworthy. First, as a substantive matter, the outcome in McPadden contrasts sharply with the recent decision in Lyondell, where Vice Chancellor Noble denied a motion for summary judgment and permitted a case to go to trial after finding triable issues of fact over whether the directors acted in bad faith. In Lyondell, the outside directors relied on the CEO to orchestrate and run a sale process, and the Court credited for purposes of summary judgment the plaintiffs’ assertion that the directors sufficiently abdicated their duties to permit an inference of bad faith.

The facts as alleged in McPadden appear more egregious: the transaction was a sale to an insider, and the directors knew about Dubreville’s conflict and the problems with the sale process yet went forward anyway. Under Vice Chancellor Noble’s approach in Lyondell, the McPadden complaint would seem to have stated a claim because of a permissible inference of bad faith. The Chancellor reaches a different result by reading Stone v. Ritter as requiring intentional dereliction of duty and moving recklessness into the category of gross negligence.

Stone v. Ritter involved a Caremark claim based on the lack of a reporting system to ferret out wrongdoing. It is not clear to me that Stone‘s comments on bad faith in that context apply broadly to all types of bad faith. Indeed, Stone’s language on the nature of bad faith is drawn from Walt Disney, in which the Supreme Court described its definitions of bad faith as illustrative and not exhaustive. When director action is involved, it seems to me that recklessness of the type described in McPadden, involving the knowing delegation of duties and reliance on a conflicted fiduciary, could fall within the ambit of bad faith.

It also seems to me that in a Revlon context like Lyondell or the Revlon-like context of selling a significant subsidiary, recklessness could qualify as bad faith. Given the still evolving nature of the law in this area, Lyondell was the more conservative decision. McPadden represents a much stronger and more pro director-defendant interpretation of Stone and what “good faith” means. Directors and practitioners who reacted negatively to Lyondell can take comfort in McPadden. In the long run, however, a legal system that regularly exculpates the type of reckless conduct alleged in McPadden and does so at the pleadings stage risks having investors turn elsewhere for protection.

Second, the clear holding that officers have the same duties as directors is a welcome clarification of Delaware law. Although other decisions had hinted at this or assumed it to be true, we now have a decision that says it. Even without this holding, I do not see how Dubreville would have qualified for exculpation given his personal financial interest in the deal.

Third, as a procedural matter, the Chancellor declined to apply Section 102(b)(7) in the context of Rule 23.1 and instead held that an exculpated care claim was sufficient to merit denial of a Rule 23.1 motion under the second prong of Aronson. From a practitioner perspective, this means that defendants who wish to invoke Section 102(b)(7) must make both a Rule 23.1 motion and a Rule 12(b)(6) motion. This is not overly difficult and in Delaware can be accomplished via the same motion and supporting brief.

Nevertheless, it could easily be overlooked because Rule 23.1 generally applies a stricter standard and is typically the dispositive motion. In addition, in the context of Rule 23.1 motions under Rales v. Blasband, which applies when the demand futility evaluation focuses on a new board, Section 102(b)(7) is applied directly at the Rule 23.1 stage to determine whether or not the directors have a reasonable fear of liability. Practitioners therefore should be careful not to overlook the need to make a Rule 12(b)(6) motion in the Aronson context.