October 14, 2021

Special Committees: “Bad Faith” Claims Gain a Foothold in Delaware

This Cooley blog discusses a couple of recent Chancery Court decisions that have refused to dismiss claims that special committee members breached their fiduciary duty of loyalty by acting in bad faith. Here’s the intro:

Special committees, by design, are created to address conflicts and to insulate the board of directors from liability for the very conflicts that may invite judicial scrutiny of the fairness of the board’s decision. A well-functioning special committee will also mitigate the risk of personal liability for a company’s fiduciaries, reducing the likelihood of protracted post-closing litigation. Directors of Delaware public companies are typically exculpated for monetary liability for duty of care claims under their company’s charter.

In that case, the only hook for monetary liability against a director is a duty of loyalty breach, which requires the plaintiff to allege that the director was interested in the transaction, lacked independence in the transaction or acted in bad faith. A properly constituted special committee should eliminate the ability to allege both interest in the transaction or lack of independence, leaving only bad faith as a basis for breach of loyalty claims against directors serving on the committee.

The Delaware Court of Chancery has acknowledged that a “finding of bad faith in the fiduciary duty context is rare” but despite that acknowledgment, in two separate decisions this year (In Re Pattern Energy Group Inc. Stockholders Litigation (“Pattern Energy”) and The MH Haberkorn 2006 Trust, et al. v. Empire Resorts, Inc., et al. (“Empire Resorts”)), the court allowed bad faith claims against special committee members to survive a motion to dismiss. These decisions, which are described in more detail below, highlight the importance of a committee’s role in managing conflicts, particularly when it is made aware of potential wrongdoing by conflicted fiduciaries.

The blog reviews the facts and the Chancery Court’s decision in both of these cases, and stresses the critical importance of proper committee oversight of the activities of conflicted members of management or other fiduciaries. While conflicted fiduciaries aren’t prohibited from any participation in the sale process, the special committee must be attentive to the issues that their participation raises – most notably the possibility that the conflicted parties might try to tip the deal in favor ot their preferred buyer.

In order to manage these concerns, the blog makes a number of recommendations.  Among other things, the authors suggests that conflicted fiduciaries should be excluded from committee deliberations, although they may participate in presentations to and respond to questions from the special committee. The committee should also ensure that conflicted fiduciaries aren’t put in position to control messaging to bidders or make significant negotiating decisions.

I think this was all the kind of good advice that most lawyers would have given to special committees before these decisions, but the fact that Delaware courts are raising the possibility of unexculpated personal liability for special committee members means that the audience may be more receptive to the message.

John Jenkins