Gantler v. Stephens; Board's Failure to Accept Merger Proposal to Pursue Reclassification of Stock Not Entitled to Presumption of Business Judgment

The Delaware Supreme Court’s en banc decision in Gantler v. Stephens, 2009 WL 188828 (January 27, 2009) illustrates the hazards of pursuing change of control transactions lackadaisically and the risks in alienating a sitting director. As a result, decisions that might normally be protected by the business judgment rule received more exacting entire fairness review. Under the more exacting standard, the Delaware Supreme Court concluded, in an opinion by Justice Jacobs, that the defendants’ motion to dismiss had been improperly granted by Vice Chancellor Parsons. In the course of its decision, the Supreme Court takes the occasion to confirm that officers are subject to the same fiduciary duties as directors under Delaware law, and clarifies the application of the doctrine of shareholder ratification.

A. How Not to Run a Transaction

First Niles Financial, Inc. (“First Niles” or the “Company”) is a Delaware corporation headquartered in Niles, Ohio. It is a holding company formed as the result of the demutualization of a single branch S&L (the “bank”) located in Niles. Its board of directors was insular, consisting of First Niles’ long-time Chairman, President and CEO William L. Stephens, plaintiff Leonard T. Gantler (director from April 2003 through April 26, 2006 and a CPA), James Kramer, president of a local heating and air conditioning company that provided services to the bank and for whom the bank was a major client, Ralph Zuzolo, principal in a Niles law firm that provided legal services to the bank and the sole owner of a real estate title company that provided title services for nearly all of the bank’s real estate transactions, and a fifth director.

In August 2004 the board decided to put the Company up for sale. It retained Keefe, Bruyette & Woods as its financial advisor.

Demonstrating its lack of enthusiasm for the proposal, management, headed by Stephens, advocated abandoning the search at the very next meeting of the board and proposed, instead, that the Company go private. The board took no action on management’s proposal. Three potential purchasers surfaced. Two of them were explicit that they would replace the Company’s board. Keefe Bruyette advised the board that all three bids reasonably valued the Company.

Notwithstanding the board’s direction to management and Keefe Bruyette to conduct due diligence in connection with two of the proposals, management failed to provide due diligence materials to one of the bidders, resulting in its withdrawal of its proposal. The remaining bidder, First Place Financial Corp. (“First Place”), after itself being delayed with its due diligence requests, proposed a stock-for-stock transaction which, as revised, represented an 11% premium over First Niles’ stock price. Keefe Bruyette opined that the offer was within an acceptable range.

Here is the Court’s recitation of the sum and substance of the board’s consideration of First Place’s revised proposal:

“On March 8, First Place increased the exchange ratio of its offer to provide an implied value of $17.37 per First Niles share. At the March 9 special Board meeting, Stephens distributed a memorandum from the Financial Advisor describing First Place’s revised offer in positive terms. Without any discussion or deliberation, however, the Board voted 4 to 1 to reject that offer, with only Gantler voting to accept it. After the vote, Stephens discussed Management’s privatization plan and instructed Legal Counsel to further investigate that plan.”

Slip Opinion at 7.

B. Management’s Reclassification Proposal

After the board rejected First Place’s offer, it thereafter considered management’s privatization proposal which included, among other components, reclassifying the shares of holders of 300 or fewer shares of the Company’s common stock into a new issue of Series A Preferred Stock, which would pay higher dividends but not carry any voting rights (except in the event of the proposed sale of the Company) (the “Reclassification Proposal”). In December 2005, after hearing a presentation from Powell Goldstein LLP, Atlanta, as special counsel retained for the privatization, the board elected to proceed with the Reclassification Proposal by a vote of three to one, with Gantler dissenting.

After Gantler resigned from the board in April 2006, the board elected to proceed with the Reclassification Proposal in June of 2006, which, because it entailed an amendment to the Company’s Certificate of Incorporation, required stockholder approval.

C. The Company’s Proxy Statement

In its proxy statement distributed to its stockholders soliciting their approval of the Reclassification Proposal and the amendment to the Company’s Certificate of Incorporation, the proxy statement acknowledged that the Company’s directors and officers were subject to a conflict of interest with respect to the Reclassification Proposal. In disclosing the alternatives the board had considered to the Reclassification Proposal, the proxy statement stated, with respect to the First Place proposal, that “[a]fter careful deliberations, the board determined in its business judgment the proposal was not in the best interests of the Company or our shareholders and rejected the proposal.” Slip Opinion at 10.

57.3% of the outstanding shares voted in favor of the Reclassification Proposal, although, with respect to shares held by stockholders not affiliated with management, the proposal passed by a bare 50.28% majority vote.

D. Business Judgment Standard Not Available to the Company’s Board

In reviewing Vice Chancellor Parsons’ grant of defendants’ motion to dismiss, the Supreme Court reviewed plaintiffs’ complaint “in the light most favorable to the non-moving party, accepting as true its well-pled allegations and drawing all reasonable inferences that logically flow from those allegations.” Slip Opinion at 12-13 (footnote omitted).

The Supreme Court first agreed with Vice Chancellor Parsons that the Unocal standard of review did not apply (Unocal v. Mesa Petroleum Co., 493 A.2d 946 (Del. 1995)) because the conduct challenged did not involve any “defensive” action by the Company’s board:

“The Court of Chancery properly refused to apply Unocal in this fashion. The premise of Unocal is ‘that the transaction at issue was defensive.’ Count I [alleging breach of fiduciary duty in the conduct of the sales process] sounds in disloyalty, not improper defensive conduct. Count I does not allege any hostile takeover attempt or similar threatened external action from which it could reasonably be inferred that the defendants acted ‘defensively.’”

Slip Opinion at 17 (footnotes omitted).

But the Supreme Court did find that Vice Chancellor Parsons misapplied the business judgment rule. A board is entitled to the protection of the business judgment rule unless the plaintiff pleads facts supporting either a breach of the board’s duty of loyalty or its duty of care. Here plaintiffs alleged that the First Niles board improperly rejected a “value-maximizing” bid from First Place and terminated the sales process to preserve personal benefits and valuable outside business opportunities for management and the interested directors.

While a board’s decision not to pursue a merger opportunity is normally reviewed within the traditional business judgment framework, that framework is not available to defendants where plaintiffs plead facts establishing a cognizable claim that a board acted disloyally. Here the plaintiffs did so. The Supreme Court had little difficulty in finding that three of the four directors who rejected the First Place bid acted, on the facts pled, disloyally: Stephens, by his failure to cooperate with the bidders; Kramer because he suffered from a “disqualifying” conflict by reason of his dependence upon the bank as a major client of his service company; and Zuzolo likewise because of his heavy reliance upon the bank for his income.

In the course of its analysis, the Supreme Court takes the occasion to expressly affirm that officers of Delaware corporations owe the same fiduciary duties to stockholders as directors do:

“In the past, we have implied that officers of Delaware corporations, like directors, owe fiduciary duties of care and loyalty, and that the fiduciary duties of officers are the same as those of directors. We now explicitly so hold."

Slip Opinion at 24 (footnotes omitted).

(In so holding, the Court notes that corporate officers, unlike corporate directors, are not expressly included in Section 102(b)(7) of Delaware’s GCL, permitting the certificate of incorporation of a Delaware corporation to include a provision eliminating or limiting the personal liability of a director to the corporation or its stockholders from monetary damages for breach of fiduciary duty, subject to specified exceptions. Expect this omission to become an agenda item for the Delaware Legislature. The Court’s holding also points up the importance of indemnification agreements for officers.)

E. Clarification of the Shareholder Ratification Doctrine

The Supreme Court also takes the occasion of this decision to clarify the application of Delaware’s shareholder ratification doctrine. Vice Chancellor Parsons concluded that the approval by the stockholders of First Niles of the Reclassification Proposal “ratified” the board’s decision to pursue it, thereby entitling it to business judgment protection. The Supreme Court reversed this decision and takes the occasion to clarify that the shareholder ratification doctrine is limited to its “classic” form, meaning that it applies only where shareholders vote to approve director action that is not legally required of the shareholders in order for the action to become legally effective:

“To restore coherence and clarity to this area of our law, we hold that the scope of the shareholder ratification doctrine must be limited to its so-called ‘classic’ form; that is, to circumstances where a fully informed shareholder vote approves director action that does not legally require shareholder approval in order to become legally effective. Moreover, the only director action or conduct that can be ratified is that which the shareholders are specifically asked to approve. . . . the ‘cleansing’ effect of such a ratifying shareholder vote is to subject the challenged director action to business judgment review, as opposed to ‘extinguishing’ the claim altogether (i.e., obviating all judicial review of the challenged action).”

Slip Opinion at 33-34 (footnotes omitted) (emphasis in original).
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There are two sets of losers as a result of the Supreme Court’s reversal of Vice Chancellor Parsons’ ruling. First there are the defendants, whose management of the First Niles sales process and consideration and adoption of the Reclassification Proposal comes across as amateurish and transparently self-interested. The second loser is Vice Chancellor Parsons himself, whose rulings and reasoning are treated brusquely by the Supreme Court, almost as if they concluded he had been tone deaf to the self-interested conduct of the First Niles board. Vice Chancellor Parsons took some seven months to prepare his opinion below (the case was submitted to the Vice Chancellor on July 11, 2007 and he decided it on February 14, 2008): his bosses showed little regard for all that work.