Thursday, September 11, 2008

Are the Chancery Court's Decisions in Ryan v. Lyondell Chemical Company and McPadden v. Sidhu Incompatible?

Two recent decisions in the Delaware Chancery Court address the effect of Delaware’s director exculpatory provision, Section 102(b)(7) of the Delaware General Corporation Law (“GCL”) in the context of a M&A transaction, with dramatically different results. In Ryan v. Lyondell Chemical Company, 2008 WL 2923427 (July 29, 2008) (“Ryan”) Vice Chancellor Noble concluded, in ruling on defendants’ motion for summary judgment, that Section 102(b)(7) did not shield the directors from potential liability. In McPadden v. Sidhu, 2008 WL 4017052 (August 29, 2008) ("McPadden"), Chancellor Chandler ruled, on a motion to dismiss, that Section 107(b)(7) was available to the directors of i2 Technologies, Inc. (“i2”). Both decisions are head scratchers.

A. Ryan

On the surface, the directors of Lyondell Chemical Company should have been praised, not buried. Lyondell merged with a subsidiary of Basell AF (“Basell”) in December 2007 for a cash price of $48 per share, representing a 45% premium over the “clear day” closing price of Lyondell’s outstanding shares before Basell’s interest in Lyondell became apparent with the filing of its Schedule 13D on May 11, 2007, and a 20% premium over Lyondell’s closing price the day before the merger was publicly announced. The stockholders liked the deal: 99.33% of those who voted approved the merger!

But there is more, concluded the Vice Chancellor. Critical to his analysis is his application of “enhanced judicial scrutiny” to the process followed by the board based upon the teachings of Revlon, Inc. v. MacAndrews & Forbes Holdings, Inc., 506 A.2d 173 (Del. 1986) and its progeny. As summarized by Vice Chancellor Noble:

“The ultimate question is whether the process implemented by the board was a reasonable effort to advance the interests of the shareholders under the circumstances. A board of directors has considerable latitude in structuring the sale process, provided that it acts with demonstrable diligence in the pursuit of the best transaction reasonably available.”

Slip Opinion at 37.

On the record before him, Vice Chancellor Noble concluded that the board of Lyondell did not meet the test, based upon these findings:

· The merger agreement with Basell was done in a hurry. The entire deal was negotiated, considered, and agreed to in less than seven days.

· The board met formally to discuss the Basell proposal for a total of no more than six or seven hours, with half, if not more, of the that time devoted to reviewing the final terms of the merger agreement and voting to approve the deal.

· Notwithstanding Basell’s filing of a Schedule 13D disclosing its unannounced acquisition of 8.3% of Lyondell’s outstanding shares in May 2007, the board decided to do nothing, awaiting further events. It did not retain an investment banker to advise it or ask management to prepare projections to evaluate the company.

· Prior to agreeing to the merger with Basell, the board made no effort to conduct a formal market check of any kind.

· There was little evidence that the board negotiated the Basell proposal or actively participated in the sale process, leaving the negotiations, such as they occurred, to the CEO, and the critical negotiations, over price, occurred prior to the board’s even being informed of the Basell proposal.

· The board did not engage in an effective and relatively unencumbered post-signing market check.

Barkan v. Amsted Industries, 567 A.2d 1279 (Del. 1999) establishes a limited exception to the active sale process generally mandated by Revlon. The Barkan exception excuses an auction or pre-signing market check where the board possesses a body of reliable evidence with which to evaluate the fairness of a transaction. Vice Chancellor Noble found evidence to suggest that the Lyondell board had such knowledge, including that the members of the board were active and sophisticated; routinely advised of the financial outlook and condition of the company; involved in the purchase of Lyondell’s interest in a joint venture with CITGO in mid-2006, and thus aware of the market for refinery assets (one of Lyondell’s main lines of business); aware of one other transaction in the specialty chemicals business (Apollo’s acquisition of Huntsman in mid-2007, after Apollo was rebuffed by Lyondell’s CEO); and the board reviewed detailed financial analyses presented on the Basell proposal from both management and Lyondell’s financial advisor, Deutsche Bank. The board was also aware, of course, that Lyondell had, in effect, been “in play” since Basell’s filing of its Schedule 13D in May 2007, and yet no party had made a serious run (other than Basell) at Lyondell. Finally, between July and November of 2007 (when the stockholder vote took place, a period of some four months), no indications of interest or topping bids were received by the company. And the board knew, of course, that Dan Smith, Lyondell’s CEO, who is knowledgeable about the company and its markets, had effectively negotiated, in face-to-face negotiations with the controlling shareholder of Basell, an increase in the deal price from $40 to $48 per share.

So why did the Vice Chancellor conclude that the Barkan exception to the board’s Revlon duties did not apply here? On the record before him, the Vice Chancellor could not conclude that the Barkan exception was available because of the factors outlined above that lead the Vice Chancellor to conclude that the board had not met its Revlon duties.

The Vice Chancellor also found the board too supine in its agreement to the deal protections demanded by Basell, including a $385 million termination fee, matching rights, and a no-shop provision (and retention of Lyondell’s poison pill, other than as to Basell). Again applying “enhanced judicial scrutiny” to the board’s agreement to the deal protection measures, the Vice Chancellor found the board’s conduct wanting:

“In other words, where there is lingering doubt as to the Board’s efforts to ensure that it had secured the ‘best’ transaction available to the Lyondell shareholders before it endorsed the transaction, the Court also should be skeptical of the wisdom of the Board’s decision to grant considerable deal protections, simply as a matter of course, that limited its ability to discharge proactively its fiduciary obligations after the fact. On summary judgment, without undisputed and sufficient evidence of either a proactive market check or that the Board, in fact, ‘knew’ that it had secured the best deal reasonably available to the stockholders, one cannot exclude the inference that the deal protections agreed to by the Board serve no purpose other than to squelch even the remotest possibility of a competing bid that might have increased the price for the stockholders.”

Slip Opinion at 50-51 (footnotes omitted).

Lyondell’s certificate of incorporation contained a GCL § 102(b)(7) exculpatory provision. That section permits a Delaware corporation to include in its charter a provision “eliminating or limiting the personal liability of a director to the corporation or its stockholders for monetary damages for breach of fiduciary duty as a director, provided that such provision shall not eliminate or limit the liability of a director : (i) [f]or any breach of the director’s duty of loyalty to the corporation or its stockholders; (ii) for acts or omissions not in good faith or which involve intentional misconduct or a knowing violation of law; . . . .”

Ryan involves a post-merger challenge, and accordingly Ryan, on behalf of the former Lyondell stockholders, was seeking money damages. Lyondell’s exculpatory provision was thus in play. Vice Chancellor Noble thus had to address whether the failure of the Lyondell board to comply with its Revlon duties was “not in good faith.”

Given that a finding that a board has failed to act in good faith “requires conduct that is qualitatively different from, and more culpable than, the conduct giving rise to a violation of the fiduciary duty of care (i.e., gross negligence),” Stone v. Ritter, 911 A.2d 362, 369 (Del. 2006) (footnote omitted), the most surprising aspect of Vice Chancellor Noble’s opinion is that he devotes only three pages of his 73-page opinion to disposing of the defendants’ argument that, even if they breached their Revlon duties, Lyondell’s certificate and GCL § 102(b)(7) precluded an award of damages. Here the Vice Chancellor relied upon the following language of the Delaware Supreme Court in Stone v. Ritter:

“Where directors fail to act in the face of a known duty to act, thereby demonstrating a conscious disregard for their responsibilities, they breach their duty of loyalty by failing to discharge that fiduciary obligation in good faith.”

911 A.2d at 370 (footnotes omitted).

Applying this test, Vice Chancellor Noble concluded that Section 102(b)(7) did not, at this stage of the proceedings, exonerate the directors:

“The record, as it presently stands, does not, as a matter of undisputed material fact, demonstrate the Lyondell directors’ good faith discharge of their Revlon duties – a known set of ‘duties’ requiring certain conduct or impeccable knowledge of the market in the face of Basell’s offer to acquire the Company. . . . With a record that does not clearly show the Board’s good faith discharge of its Revlon duties, however, whether the members of the Board are entitled to seek shelter under the Company’s exculpatory charter provision for procedural shortcomings amounting to a violation of their known fiduciary obligations in a sale scenario presents a question of fact that cannot now be resolved on summary judgment.”

Slip Opinion at 56 (emphasis added).

What is surprising about the Vice Chancellor’s conclusion is that he devotes almost no effort to explicating Stone v. Ritter’s use of the word “conscious” before “disregard for their responsibilities . . .” as applied to Ryan. It’s almost as if, at this point in his struggle over this decision, he had little left to analyze whether additional culpability was required from the Lyondell board to find not only a breach of Revlon duties but also a conscious violation of their Revlon duties.

B. McPadden

McPadden stands in stark contrast to Ryan. Vice Chancellor Noble obviously struggled with his decision in Ryan, which is not only apparent from the text of the decision, with its extensive “on the one hand, on the other hand” analyses, but also from the length of time it was in gestation (submitted December 5, 2007, decided July 29, 2008). Chancellor Chandler had an easier time with his decision in McPadden, as is obvious both from the text and its time in gestation (submitted June 17, 2008, decided August 29, 2008). If Vice Chancellor Noble’s failure to exonerate the board of Lyondell in Ryan is surprising, then Chancellor Chandler’s exoneration of the board in McPadden is even more surprising.

This case also involves a post-merger challenge to the sale by i2, a Delaware corporation, of its wholly-owned subsidiary, Trade Services Corporation (“TSC”). TSC was sold to a management team led by a then TSC Vice President, defendant Anthony Dubreville, for $3 million. Six months after the sale, Dubreville rejected a $18.5 million offer for TSC as too low. He sold it to another company two years after he purchased it from i2 for $25 million. No surprise – this lawsuit followed.

Plaintiff brought this derivative action against the board of directors of i2 and Dubreville for breach of fiduciary duty and, against Dubreville only, for unjust enrichment. While Dubreville was not a director of i2, he was an officer of TSC.

On this motion to dismiss, the facts are taken from plaintiff’s complaint, and subject to the usual caveats. But on the facts alleged, the process followed by the board of directors of i2 to sell TSC would qualify for inclusion in a textbook on corporate governance as an example of how not to run a deal:

· In late 2004 early 2005, the board decided to sell TSC after determining it was a non-core business that should be divested.

· In July 2002, a TSC competitor (“VIS”), with whom TSC was then in litigation, expressed an interest in buying TSC and made that interest known to i2’s then directors. VIS repeated this interest several times during 2002. In January 2003, VIS advised a director of i2 and its CFO that it would be willing to pay up to $25 million for TSC.

· On February 1, 2005, by which time the board was aware that Dubreville wanted to lead a management-led buyout of TSC, the board resolved to sell TSC. The board appointed Dubreville to conduct the sales process!

· Two versions of the pitch book for TSC were prepared, one in January 2005 and a second in February 2005. The February 2005 edition used significantly reduced projections of TSC’s revenues and income. The February 2005 edition was used by Dubreville to solicit bids for TSC.

· Dubreville did not solicit interest from any of TSC’s direct competitors to purchase TSC. He did not solicit any interest from VIS, even though he and at least three of i2’s then directors knew that VIS had “indicated a strong interest in buying TSC and had offered as much as $25 million for TSC in 2003.”

· Dubreville ultimately secured three offers for TSC, one of which was rejected because it was a bundled bid seeking two of i2’s businesses (one of which was not up for sale). One bid, for $1.8 million, was from Dubreville’s former boss and his partner in a printing company. The third was from Dubreville’s group, for $3 million, consisting of $2 million in cash and $1 million in software licensing agreements.

· On April 18, 2005, the board met to consider Dubreville’s offer for TSC. i2’s investment banker, Sonenshine Partners, gave the board its preliminary valuation of TSC at from $3 million to $7 million (using February’s management projections) and $6 million to $10.8 million using the January projections. The board approved the sale of TSC to Dubreville’s group.

· The letter of intent with Dubreville was signed on April 22, 2005. No negotiations over the letter of intent were conducted between the board or its special committee and Dubreville.

· The special committee of the board, charged with reviewing the fairness of the sale of TSC to Dubreville’s group, first met with i2’s investment banker on June 21, 2005, the week before the sale was finally approved.

· On June 28, 2005 the special committee and the board met and approved the sale of TSC to Dubreville’s group.

Because this is a derivative action, Chancellor Chandler first had to resolve whether demand was excused on i2’s board of directors under Chancery Rule 23.1. Because plaintiff made no demand on i2’s board, she had to establish, by particularized pleading in her complaint, that the sale to TSC “was otherwise [than] the product of a valid business judgment.”

Not surprisingly, Chancellor Chandler concluded that this test was met and, indeed, on the facts alleged by plaintiff in her complaint, the board of i2 had been grossly negligent in the process it followed in selling TSC to Dubreville’s group. The Chancellor was most exercised, understandably, by the board’s selection of Dubreville to conduct the sale. On the facts alleged by plaintiff, the Chancellor had little hesitation in finding that the board had been grossly negligent:

“In making its decisions, the board had no shortage of information that was both material — because it affected the process and ultimate result of the sale — and reasonably available (or, even, actually known as evidenced by the discussions at the board meetings): Dubreville’s interest in leading a management buyout of TSC’s; Dubreville’s limited efforts in soliciting offers for TSC, including his failure to contact TSC competitors, including one he knew had previously expressed concrete interest in purchasing TSC; the circumstances under which the January and February projections were produced; the use of those projections in Sonenshine’s preliminary valuations of TSC; and that TSH [Dubreville’s company] was a group led by Dubreville. That the board would want to consider this information seems, to me, so obvious that it is equally obvious that the Directors Defendants’ failure to do so was grossly negligent.”

2008 WestLaw 4017052 at *8.

In light of the process followed by the i2 board, what Chancellor Chandler does next is surprising: he grants the director defendants’ motion to dismiss because of the exculpatory provision of i2’s certificate of incorporation and Section 102(b)(7) of the GCL. Relying upon the Supreme Court’s decision in Disney (In re Walt Disney Derivative Litigation, 906 A.2d 27 (Del. 2006)) and Stone v. Ritter, discussed above, Chancellor Chandler concludes that more than gross negligence is required to establish lack of good faith and that the director defendants of i2, on the facts alleged, were guilty of the former but not the latter:

“Thus, from the sphere of actions that was once classified as grossly negligent conduct that gives rise to a violation of the duty of care, the Court has carved out one specific type of conduct — the intentional dereliction of duty or the conscious disregard for one’s responsibilities — and redefined it as bad faith conduct, which results in a breach of the duty of loyalty.”

Id. at *9.

Gross negligence, concludes Chancellor Chandler, is “conduct that constitutes reckless indifference or actions that are without the bounds of reason.” The i2 directors fell within the grossly negligent boundary and not within the bad faith boundary.

I find the Chancellor’s analysis cryptic and confusing. What more could the board of i2 have done to establish a “conscious disregard of their duties”?

If, as Vice Chancellor Noble concludes, Revlon requires “enhanced scrutiny” of a board’s sale of a company, then how is it that the i2 board’s conduct, in selling TSC, did not constitute a “conscious disregard” of their responsibilities under Revlon? Perhaps Revlon does not apply to the sale of a subsidiary, as opposed to the sale of an entire company. Chancellor Chandler does not mention Revlon, so perhaps he analyzed the i2 board’s duties under the Caremark standard, applicable to normal board supervision, as opposed to the “enhanced scrutiny” required by Revlon when a board conducts a sale of a company. On the other hand, the form followed by the i2 board – special committee, retention of investment banker, preparation of pitch books – adhered to the Revlon rubric, and therefore if Chancellor Chandler concluded sub silento that this was not a Revlon case, it would have been helpful for him to have said so.

Not all was lost for plaintiff, however, as Dubreville’s status as an officer of TSC but not a director of i2 saved the day: Officers are not eligible for exculpation under Section 102(b)(7), and therefore the Chancellor denied Dubreville’s motion to dismiss both the claim of breach of fiduciary duty against him and plaintiff’s claim for unjust enrichment. Certainly on the scale of rough justice, that is a right result.

C. Vice Chancellor Noble Criticized By His Colleagues?

There have been considerable grumblings about Vice Chancellor Noble’s decision in Ryan. See the article in The Daily Deal (September 5, 2008) (page 3). The author of The Daily Deal article reads Chancellor Chandler’s decision in McPadden and Vice Chancellor Strine’s decision in Lear (In re Lear Corporation Shareholder Litigation, 2008 WL 4053221 (September 2, 2008)) as joining in the chorus of criticism. Chancellor Chandler’s decision can be read as squarely in conflict with the analysis of Vice Chancellor Noble in Ryan if the boards in both cases were subject to Revlon duties, but can be reconciled if Revlon did not apply to the sale of TSC by the i2 board of directors.

I will address Vice Chancellor Strine’s decision in Lear in a subsequent post.

1 comment:

Spirit said...

The case is now quashed, since JDA Software acquired i2 Technologies, and under Delaware law that ends McPaden's holding of i2 stock. McPadden, by the way, was almost right in his assertions. The Vision InfoSoft offer was an over-valuation, because VIS was trying to acquire TSC to avoid losing a lawsuit (which they ultimately did lose). The spin-out of Trade Service was actually for a substantially greater price than i2 admitted. Most of the purchase was structured as purchase of i2 software and services, much of which TSC did not really need. So the real crime was not unjust enrichment for Dubreville but securities fraud on the part of the i2 board.