March 27, 2009

Game Changer: Delaware Supreme Court Reverses in Lyondell

We have begun posting memos on the Lyondell decision in our “Fiduciary Duties” Practice Area. Even though I blogged about it yesterday, the case is important enough to also blog the following analysis from Travis Laster:

On Wednesday, the Delaware Supreme Court issued this decision reversing Vice Chancellor Noble’s denial of summary judgment in Lyondell. I expect much will be written about this case, because it is a game changer.

In my view, the decision goes a long way towards eliminating the possibility of a loyalty claim for failure to act in good faith where the claim is the directors allegedly “knew” that their fiduciary duties required particular action. It also goes a long way towards eliminating any possibility of a post-closing damages remedy in a Revlon scenario involving independent directors. The major short-term impact of the decision, I believe, will be to shift the focus of parties challenging mergers to the injunction phase, because post-closing challenges will no longer be viable in most instances. It remains to be seen whether Lyondell’s approach to review of a sale process will also permeate the pre-closing world of injunction practice.

Analysis of the Reversed Chancery Court’s Decision

The process in Lyondell was the type of CEO-driven affair that Delaware courts have cautioned against since the 1980s. Here is my description on Vice Chancellor Noble’s decision:

“[A] stockholder plaintiff challenged the cash sale of a chemical company to a strategic acquirer at a 45% premium to the unaffected market price. The deal was approved by a board comprised of 10 indisputably independent outsiders and the CEO. Prior to the acquirer filing a 13D, the target was healthy and not in financial distress. It was also not for sale, and the board had not run any type of process or engaged in recent efforts to determine the sale value of the company. The CEO fielded the inquiry and led the negotiations, getting well out in front before bringing the board in, setting the acquirer’s price expectation at $48 per share without board input, and then going to the board for approval and a fairness opinion.

To the CEO’s credit, there was apparently no discussion of his personal situation, and the CEO rebuffed a competing LBO inquiry as presenting too many conflicts. Nevertheless, he was clearly in the lead, and the entire process of board consideration and approval spanned just one week. The merger agreement had standard deal protections, with a no-shop, matching rights, and a break fee equal to 3% of equity value and 2% of enterprise value. There was no post-agreement go shop, just the inherent market check that accompanies any announced deal with this combination of provisions.”

On these facts, Vice Chancellor Noble denied the defendants’ motion for summary judgment, finding that the lack of involvement by the Board and the CEO-driven process gave rise, at the summary judgment stage, to a permissible inference of bad faith. He therefore denied summary judgment, while signaling strongly that the directors would prevail on the merits at trial.

The Delaware Supreme Court accepted a rare interlocutory appeal from this decision and reversed.

Analysis of the Supreme Court’s Decision

Because Lyondell had a 102(b)(7) provision and a majority-independent board, the Supreme Court held that the directors only could face liability if they acted in bad faith by “knowingly and completely failed to undertake their responsibilities.” (18). Accordingly, the Supreme Court held that “the inquiry should have been whether those directors utterly failed to attempt to obtain the best sale price.” (19). In holding that the directors satisfied this standard, the Court assumed “that the Lyondell directors did absolutely nothing to prepare for Basell’s offer, and that they did not even consider conducting a market check before agreeing to the merger.” (19).

Compare this language with prior Supreme Court decisions, which taught that a “board of directors . . . may not avoid its active and direct duty of oversight in a matter as significant as the sale of corporate control.” Mills Acquisition Co. v. MacMillan, Inc., 559 A.2d 1261, 1281 (Del. 1988). A similar lesson was that “directors cannot be passive instrumentalities during merger proceedings.” Citron v. Fairchild Camera and Instrument Corp., 569 A.2d 53, 66 (Del. 1989). They were told to provide “serious oversight,” Mills, 559 A.2d at 1265, and that their fiduciary duties required that they “take an active and direct role in the context of a sale of a company from beginning to end.” Cede & Co. v. Technicolor, Inc., 634 A.2d 345, 367 (Del. 1993). These obligations were not limited to management buyouts or conflict situations but rather applied to all potential change of control transactions. Paramount Comm., Inc. v. QVC Network, Inc., 637 A.2d 34, 44 (Del. 1994). Ultimately, under QVC, the directors had the burden of proof to establish that they acted reasonably to obtain the best transaction reasonably available. Id.

The language of Lyondell suggests a different approach to judicial review of a sale process. While anything is theoretically possible, it is difficult for me to imagine the case where independent directors will have “utterly failed to attempt to obtain the best price” or “knowingly and completely failed to undertake their responsibilities.” My takeaway from Lyondell is that a majority-outsider board no longer faces post-closing litigation risk for a Revlon sale but rather can rely on summary judgment plus a 102(b)(7) provision to eliminate the case. This in turn has major and readily apparent implications for case strategy and settlement leverage.

Because Lyondell is a post-closing damages case, it is possible to view its language as limited solely to that context. Under that reading, the old learning, burdens of proof, and standard from QVC would continue to apply in the injunction context. If so, then the logical move for plaintiffs is to shift their focus entirely to injunction practice, because post-closing there will not be anything meaningful to litigate. In this regard, Lyondell echoes Chancellor Chandler’s decision grant of summary judgment in In re Transkaryotic Therapies, which implied a similar fate for post-closing damages litigation based on disclosure violations.

But if the lesson for plaintiffs from Lyondell is that the injunction is everything, then even that might not be much. Recent decisions like Netsmart and Lear suggest that plaintiffs will not have much success obtaining deal-process injunctions in the absence of a topping bid. The Court of Chancery has tended towards granting disclosure-based injunctions, including disclosures about the sale process, but otherwise allowing stockholders to decide for themselves whether to accept a premium bid. Plaintiffs thus may not fare any better in the pre-closing injunction context, and the focus will likely be primarily on disclosures.

Opining on a Limited Record

An equally problematic issue for plaintiffs is that the Supreme Court questioned in Lyondell whether the directors so much as breached their duty of care, observing “even on this limited record, we would be inclined to hold otherwise.” (17). In that regard, the facts of Lyondell are worth repeating. The CEO ran the process and was well out in front of the Board. The directors did not gather information about the value of the transaction or probe the market for competing offers. They were, in the Supreme Court’s words, “generally aware of the company’s value and its prospects.”

Their financial advisor, Deutsche Bank, was not hired until after the price was established and was charged only with preparing a fairness opinion. Deutsche Bank thus did not have any significant involvement in the negotiations over price or structure. Nor did Deutsche Bank or any other financial advisor play a role in structuring the process. And although Deutsche Bank compiled a list of potential acquirers, they were instructed not to solicit any competing offers for the company. The Board considered the Basell proposal for about 50 minutes on July 10, then discussed the proposal for approximately 45 minutes on July 11. The Board met again on July 12 and discussed the Basell proposal in executive session without management present. On July 16, the Board approved the transaction.

This was a minimalist process. Yet the Supreme Court indicated that it would not give rise to a care violation. With Lyondell as a guidepost, future plaintiffs will have difficulty establishing a reasonable probability of success on the merits of a care claim that would support the issuance of an injunction. And deal counsel (including Delaware counsel) will have difficulty advising clients that what they want to do is unlikely to pass muster. Director conflicts of interest and conflict transactions will still require careful review and nuanced advice, but Lyondell signals a largely unlimited range of action for independent boards, with market forces as the primary check and fiduciary duty review playing a lesser role.

Although these factors alone would make Lyondell a game-changing case, the decision then goes further in its analysis of good faith by noting that “there are no legally prescribed steps that directors must follow to satisfy their Revlon duties. Thus, the directors’ failure to take any specific steps during the sale process could not have demonstrated a conscious disregard of their duties. More importantly, there is a vast difference between an inadequate or flawed effort to carry of fiduciary duties and a conscious disregard for those duties.” (18)

To my mind, the softness of fiduciary duty analysis is not limited to the Revlon context. Compliance with fiduciary duties is always context-specific. It does not require pre-ordained steps, but rather the exercise of judgment. Lyondell suggests to me that while there remains room for a bad faith breach where clear statutes or regulatory requirements are concerned, there is not much room, if any, under Delaware law for a claim for bad faith breach based on failure to comply with fiduciary duties.

Thoughts on Section 102(b)(7)

A final thought on Lyondell concerns the mid-discovery, pre-trial invocation of Section 102(b)(7). In Emerald Partners v. Berlin, 725 A.2d 1215 (Del. 1999), the Delaware Supreme Court held that a Section 102(b)(7) provision could not be invoked prior to trial in an entire fairness case because the defendants had the burden of proof and it was not possible to determine, prior to trial, whether the directors’ breaches implicated the duty of loyalty or the duty of care. This contrasted with cases asserting only a breach of the duty of care, where a Section 102(b)(7) provision could be invoked routinely at the motion to dismiss stage to result in dismissal.

After Emerald Partners, it was possible that the Supreme Court would apply the same rationale to other scenarios, such as Revlon/QVC and Unocal, where the directors bore the burden of proof and where a fiduciary breach could implicate either loyalty or care. Lyondell makes no mention of Emerald Partners and the Supreme Court had no difficulty entering summary judgment for the defendants. After Lyondell, it seems clear that the Emerald Partners limitation on invoking a Section 102(b)(7) provision prior to trial applies only in cases where entire fairness applies “ab initio,” such as controlling stockholder transactions, and will not have any application in other contexts.

The underlying sense of a retreat from enhanced scrutiny under Revlon/QVC towards business judgment review in Lyondell echoes a similar approach in the recent Gantler decision, in which passages appeared to retreat from Unocal review. Lyondell and Gantler likewise both avoid mentioning any shift in the burden of proof to the director defendants, which traditionally was a hallmark of both the Revlon/QVC and Unocal frameworks.

Together, Gantler and Lyondell underscore Delaware’s continued faith in and deference to decisions made by independent directors. If anything, and consistent with Delaware’s director-centric model, the degree of deference appears to be on the upswing. For independent directors and their counsel, this is a good thing.