Nemec v. Shrader; Redemption of Shares Just Prior to a Transaction

Timing can be everything. Long-time “partners” Joseph Nemec and Gerd Wittkemper of Booz Allen Hamilton Inc. (“Booz Allen”) retired on March 31, 2006 after illustrious careers with the firm. After their retirement, Booz Allen entered into negotiations with The Carlyle Group (“Carlyle”) to sell its government consulting business for over $2 billion. Notwithstanding assurances by Booz Allen’s chairman and CEO to both Nemec and Wittkemper that Booz Allen would not exercise its discretionary option to repurchase their shares prior to consummation of the Carlyle transaction, Booz Allen in fact did so a month before Booz Allen entered into a deal with Carlyle. The early redemption cost Nemec and Wittkemper over $60 million.

Too bad, concluded Chancellor Chandler on this motion of defendants to dismiss (reported at 2009 WL 12043465 (April 30, 2009)). The discretionary redemption did not constitute a breach of the directors’ fiduciary duties to Nemec and Wittkemper, did not breach the implied covenant of good faith and fair dealing between plaintiffs and Booz Allen, and did not constitute unjust enrichment of Booz Allen. It’s a harsh result, which may feed the Chancery Court’s reputation as plaintiff-unfriendly, but undoubtedly the correct decision.

A. The Background

Nemec spent 36 years with Booz Allen. At the time of his retirement on March 31, 2006, he ranked third in seniority among all Booz Allen “partners.” (Although a Delaware corporation, the firm, originally founded as a partnership in 1914, retained the “attitude and culture” of a partnership.) He sat on Booz Allen’s board of directors where, among other things, he served on the audit committee. Wittkemper retired on the same date, March 31, 2006, after some 20 years as a partner of the firm, building the firm’s German business and helping it to expand throughout Europe.

At the time of his retirement from the firm, Nemec owned 76,000 shares of Booz Allen (representing 2.6% of the issued and outstanding stock of the firm), and Wittkemper owned 28,000 shares. Under Booz Allen’s stock plan, a retiree had a “put” right, for a period of two years from the date of his retirement, to sell his shares back to the firm for book value. After expiration of the two-year put period, Booz Allen had the right to redeem part or all of a retired officer’s stock, also at book value (as of the time of redemption). Nemec and Wittkemper (in large part) retained their Booz Allen stock after retirement. In early 2007 Booz Allen commenced discussions with Carlyle over the sale of its government consulting business. Carlyle submitted a bid in November 2007 to purchase the business for $2.54 billion. The negotiations became public in January 2008; it was reported the deal was expected to close by March 31, 2008 (the end of Booz Allen’s fiscal year). If it closed by that date, Nemec and Wittkemper would participate in the benefits of the transaction, to the extent of some $700 per share.

In light of the pending transaction, Booz Allen’s board elected, in March 2008, to preserve the status quo of Booz Allen’s stock ownership, meaning it elected not to redeem any shares so as to maintain the status quo and not “disfavor any existing stockholder.” Slip Opinion at 5-6.

Nemec and Wittkemper, aware of the pending transaction, were of course anxious to participate in its fruits. Booz Allen’s chairman and CEO gave assurance to both of them that they would remain Booz Allen stockholders until the close of the transaction. The CEO stated that this was an “easy moral decision.” Slip Opinion at 6.

Moral, maybe, but on second thought, the board eschewed morality and decided to exercise the firm’s contractual rights under the stock plan and award agreements with Nemec and Wittkemper: in April 2008, before the transaction with Carlyle was formally approved, Booz Allen redeemed the plaintiffs’ shares at the pre-transaction book value — $162.46 per share.

Within weeks of the redemption of Nemec’s and Wittkemper’s shares, the firm moved to cement the transaction with Carlyle. On May 15, 2008, it entered into a merger agreement to sell its government business to Carlyle, which was announced publicly the following day. The directors of Booz Allen, who owned more than 300,000 shares, benefited by the redemption of the plaintiffs’ shares to the tune of $6 million.

B. The Fiduciary Duty Claim

Plaintiffs first claimed that the Booz Allen directors breached their duty of loyalty to plaintiffs by exercising the firm’s option to redeem plaintiffs’ shares at the pre-Carlyle value of the shares. Notwithstanding the personal benefits derived by the directors from this decision, Chancellor Chandler was unimpressed by the claim. First, the dispute fundamentally involved a contract — the award agreement setting forth the firm’s and Nemec’s and Wittkemper’s rights with respect to their stock awards under the stock plan:

“If the ‘fiduciary claims relate to obligations or they are expressly treated’ by contract then this Court will review those claims as breach of contract claims and any fiduciary claims will be dismissed.”

Slip Opinion at 8 (footnote omitted).

The Chancellor’s interpretation of the directors’ action was a matter of contract interpretation:

“Whether the Directors possessed the right to redeem plaintiffs’ shares and whether the Directors properly exercised that right is simply a matter of contract interpretation.”

Slip Opinion at 8-9.

Going beyond where he had to, the Chancellor nevertheless reached plaintiffs’ fiduciary duty claims, and rejected them. Fatal to plaintiffs’ fiduciary duty claim was their assertion that the Booz Allen board, as fiduciaries, owed “unique” duties to them. In fact, the directors’ decision to redeem plaintiffs’ shares benefitted all other shareholders, not just the directors as shareholders. Quoting from Gilbert v. El Paso, Chancellor Chandler noted that in such instances the fact that an action may adversely affect the interests of particular shareholders is of no moment:

“[D]irectors may take whatever action that, in their proper exercise of business judgment, will best serve the interests of the corporation or the entire body of shareholders. That such action may adversely affect the interests of a particular shareholder subgroup, will, in certain instances, be unavoidable. Nonetheless, no wrong doing will have occurred if the directors are able to justify the result as furthering a paramount or overriding corporate or shareholder interest.”

Slip Opinion at 9, quoting from Gilbert v. El Paso, 1998 WL 124325 at *10 (Del. Ch. 1988), aff’d, 575 A.2d 1131 (Del. 1990).

C. Good Faith and Fair Dealing Claim

The strongest of plaintiffs’ claims was that by redeeming their shares Booz Allen violated the implied covenant of good faith and fair dealing. Plaintiffs argued that when a contract confers discretion on a party, that party is required to make the decision reasonably and in good faith. Relying upon the principle that imposing obligations upon contracting parties through the covenant of good faith and fair dealing is “a cautious enterprise and instances [of its application] should be rare,” Slip Opinion at 11, citing Superior Vision Services, Inc. v. ReliaStar Life Ins. Co., 2006 WL 2521426 (Del. Ch. 2006), the Chancellor concluded that no violation occurred here because Booz Allen exercised rights specifically granted to it under the stock plan and award agreements with plaintiffs:

“The Stock Plan is a negotiated instrument entered into freely by both parties. The implied covenant is not implicated simply because Booz Allen, by exercising its option, received the fruits of the agreed to bargain under the stock plan. Nor is the implied covenant implicated because the exercise of the option had a negative effect on plaintiffs’ bottom line.”

Slip Opinion at 12.

D. Unjust Enrichment Claim

Chancellor Chandler tarried only a moment over this claim, noting that it applies only when it would be “unconscionable” to allow a party to retain a benefit, and the Delaware courts “have consistently refused to permit a claim for unjust enrichment when the alleged wrong arises from a relationship governed by contract.” Slip Opinion at 13.

E. What Might Have Been

One cannot read this decision without thinking of the famous case of Jordan v. Duff and Phelps, Inc., 815 F.2d 429 (7th Cir. 1987), discussed in my post of September 6, 2008. Jordan also involved an employee who terminated his employment with his employer (Jordan left to take another job). Unbeknownst to Jordan at the time he quit (he also received the book value of his shares of stock), his employer, Duff and Phelps, was in negotiations to merge. Had Jordan hung around longer, he would have received substantially more for his shares.

In this celebrated decision, in which Judges Easterbrook and Posner took opposing sides (Easterbrook for the majority, Posner in dissent), the Seventh Circuit concluded that, in such circumstances, Duff and Phelps had breached its duty of full disclosure to Jordan in connection with the redemption of his stock.

Jordan would have been in play in this case if Booz Allen had begun negotiations with Carlyle before Nemec and Wittkemper announced their decisions to retire in March 2006. But, as noted by Chancellor Chandler, the negotiations with Carlyle “began to emerge” in early 2007, too late for Nemec and Wittkemper to reach for Jordan v. Duff and Phelps. Too bad. Timing is everything.