Monday, March 30, 2009

Lyondell Chemical Co. v. Ryan; The Limits of Bad Faith Claims

In an en banc decision handed down March 25, 2009, the Delaware Supreme Court took Vice Chancellor Noble to the woodshed for his refusal to grant the Lyondell board summary judgment against plaintiffs over the board’s approval of the merger of Lyondell and a subsidiary of Basell AF (“Basell”) in December 2007 for a cash price of $48 per share. The decision provides important clarification of the Revlon duties of a disinterested board, and makes clear that where a board is disinterested, establishing bad faith is a steep hill to climb.

A. The Weakness of the Vice Chancellor’s Decision

I commented on Vice Chancellor Noble’s Lyondell decision by my posts of September 11, 12 (comparing the Vice Chancellor’s decision in Ryan with Vice Chancellor Strine’s decision In re Lear Corporation Shareholder Litigation) and 15, 2008. As I noted in my post of September 11:
“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.
. . . .

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 were required from the Lyondell board to find not only a breach of Revlon duties but also a conscious violation of their Revlon duties.”

B. The Supreme Court’s Rebuff

The Delaware General Corporation Law permits the inclusion, in a certificate of incorporation, of provisions limiting the personal liability of directors of a Delaware corporation for due care violations (including gross negligence), but not “for acts or omissions not in good faith, which involve intentional misconduct or a knowing violation of law . . .” Because this was a case where Vice Chancellor Noble concluded that on the evidence before him the Lyondell board was independent and not motivated by self-interest or ill will, the issue was whether the directors breached their duty of loyalty to Lyondell by failing to act in good faith.

Reviewing its prior decisions in Disney (In re Walt Disney Derivative Litigation, 906 A.2d 27 (Del. 2006)) and Stone v. Ritter, 911 A.2d 362 (Del. 2006), the Supreme Court, in an opinion by Justice Berger, emphasized the scienter required to establish bad faith by a Delaware board:

Stone also clarified any possible ambiguity about the directors’ mental state, holding that ‘imposition of liability requires a showing that the directors knew that they were not discharging their fiduciary obligations.’”

Slip Opinion at 11.

In concluding that Vice Chancellor Noble erred on the record before him in refusing to grant the defendants’ summary judgment, the Supreme Court crucially disagreed with the Vice Chancellor that the board’s Revlon duties began with Basell’s filing of a Schedule 13D in May 2007. In response to the filing, the Lyondell board took a “wait and see” approach, for which they were faulted by Vice Chancellor Noble. In this the Vice Chancellor was wrong:

“The problem with the trial court’s analysis is that Revlon duties do not arise simply because a company is ‘in play.’ The duty to seek the best available price applies only when a company embarks on a transaction – on its own initiative or in response to an unsolicited offer – that will result in a change of control. [The Lyondell board’s ‘wait and see’ approach] was an entirely appropriate exercise of the directors’ business judgment. The time for action under Revlon did not begin until July 10, 2007, when the directors began negotiating the sale of Lyondell.”
Slip Opinion at 14-15 (footnotes omitted).

Vice Chancellor Noble, after his review of the Revlon line of cases, concluded that directors must engage actively in a sales process, and must establish that they have obtained the best available price “either by conducting an auction, by conducting a market check or by demonstrating ‘an impeccable knowledge of the market.’” Slip Opinion at 16-17 (quoting from the Vice Chancellor’s opinion).

The Lyondell board admittedly did not conduct an auction or a market check before signing up with Basell, and Vice Chancellor Noble found that they could not demonstrate that they had an “impeccable” market knowledge of Lyondell’s industry and propects. But the Vice Chancellor’s analysis was directed at the wrong question. The issue is not whether the Lyondell board exercised due care, but whether the board failed to act in good faith. That is a very different analysis, and using that analysis, the record before the Vice Chancellor mandated entry of judgment in favor of the directors.

At this point the Supreme Court took the opportunity to quote (and thereby praise) Vice Chancellor Strine from his decision in Lear, discussed in my post of September 12, 2008. The following language will surely be quoted by all defendant directors in future claims alleging disloyalty:

“Directors’ decisions must be reasonable, not perfect. ‘In the transactional context, [an] extreme set of facts [is] required to sustain a disloyalty claim premised on the notion that disinterested directors were intentionally disregarding their duties.’ [Quoting Vice Chancellor Strine in Lear.] The trial court denied summary judgment because the Lyondell directors’ ‘unexplained inaction’ prevented the court from determining that they had acted in good faith. But, if the directors failed to do all that they should have under the circumstances, they breached their duty of care. Only if they knowingly and completely failed to undertake their responsibilities would they breach their duty of loyalty. The trial court approached the record from the wrong perspective. Instead of questioning whether disinterested, independent directors did everything that they (arguably) should have done to obtain the best sale price, the inquiry should have been whether those directors utterly failed to attempt to obtain the best sale price.”

Slip Opinion at 18-19 (footnotes omitted).

C. Observations

Lyondell illustrates the crucial protection provided directors by charter document exculpatory provisions such as those allowed by Section 102(b)(7) of the GCL and by the corporation laws of other states. With such provisions, directors’ exposure for monetary damages for breach of due care claims can be virtually eliminated. While these provisions do not prevent claims seeking injunctive relief for due care violations, they provide critical protection to directors against damages for due care violations. Indeed, an individual would be ill advised to join a board without exculpatory protections such as those permitted by Section 102(b)(7) or like provisions in other jurisdictions.

The other lesson of Lyondell is the benefit of accelerated deal negotiations. Dan Smith, Lyondell’s CEO, in response to overtures by Basell’s controlling shareholder, Leonard Blavatnik, negotiated what appeared to be a fully-priced deal (getting Blavatnik to raise his offer from $40 per share to $48 per share). In response, Blavatnik insisted that the deal be accepted and a merger agreement entered into in one week. While the accelerated schedule, the lack of a market check, the board’s acceptance of Smith’s price-raising efforts without its further insistence on further price enhancements, and the board’s acceptance of deal enhancement features (hefty break-up fee, no-shop covenant, and limited poison pill waiver) deeply troubled Vice Chancellor Noble, they did not, on the full record, trouble the Delaware Supreme Court, certainly not on the question of whether the Lyondell board acted in conscious disregard of its fiduciary duties. It of course did not hurt the directors’ cause that no competing suitor surfaced during the four months between the announcement of the merger agreement and the stockholders’ meeting, or that the stockholders approved the deal by more than 99% of the voted shares, or that, as is now common knowledge, Basell, in light of the cratering of the world economy, has put Lyondell in Chapter 11.

So, as a result of the Court’s decision in Lyondell, I would expect suitors, certainly in deals believed to be fully priced, to insist upon an accelerated deal schedule, at least to the point of negotiating and announcing an agreed-upon merger agreement.